Public Utilities Reports

PUR Guide 2012 Fully Updated Version

Available NOW!
PUR Guide

This comprehensive self-study certification course is designed to teach the novice or pro everything they need to understand and succeed in every phase of the public utilities business.

Order Now

Mending Our Broken Capacity Markets

The ability to provide reliable capacity is becoming both riskier and more costly to society and investors alike.

Fortnightly Magazine - June 2006

in. What the grid needs is a capacity market that comes close to producing the same cost-effective actions in capacity deployment as it does in energy dispatch.

Bad Behavior

Capacity markets today actually motivate actions antithetical to grid reliability and economy. Markets are intended to govern economic behavior. In capacity markets, the economic behavior being addressed is quite long-term in nature:

1. Decisions on constructing a new generation or transmission asset that will have an economic life of three to five decades and that will not achieve acceptable returns if it only takes advantage of an attractive near-term market that subsequently erodes; and

2. Decisions on maintaining, preserving, and enhancing existing generation that is losing money in the near term and may not be able to survive long enough to participate in the next market uptick.

The nature of these decisions clearly is not well aligned with price signals, which, depending on the region, flick on and off in intervals that are as short as one month or even for periods of up to four years. The decisions being made in capacity markets are multi-decade decisions and are therefore optimally geared to decade-plus pricing signals. For new construction, it takes three years to site, permit, and build a gas-fired plant today—much more for solid fueled and many renewable projects. For existing generation, capital enhancement and environmental retrofit commitments involve similar planning horizons. These kinds of investments are not going to be made without some degree of long-dated revenue visibility. That long-dated revenue visibility is best provided through long-dated, contractually based capacity payment streams.

A Durable Lesson

One might argue that those kinds of long-term “merchant” capital investments were, in the recent past at least, made by firms on the basis of a combination of short-dated market signals and long-term consultant projections of forward markets. The short-lived period of investment euphoria and excess lasting from 1997 to 2001 recklessly burned through scores of billions of dollars of wasted capital, bankrupting many firms and seriously hobbling previously strong enterprises. More important for the future, it taught a durable lesson to the capital markets to be much more guarded and risk-conscious in any new capital being purportedly committed to take advantage of current or impending capacity shortfalls.

Moreover, current capacity market designs do something worse than simply not motivating the right capital investment decision making. They actively discourage the investment society needs most. Because of the structuring of short-dated market signals, market participants are incented to take advantage of, and to perpetuate, constraint. In a tight capacity marketplace, the market price for installed capacity (ICAP)/unforced capacity (UCAP) may be high, but is visible only for a short period and therefore only hedgeable for a short period.

If a market player commits to build something in a constrained zone that actually fixes the constraint, the reward this player will receive is that the market price for capacity in the newly constraint-relieved zone will drop precipitously. So the reward for doing well is to have a very poorly performing investment. Under today’s capacity market structure, one is