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A New England Capacity Market That Works

Two authors beg to differ with Goldman Sachs’ Larry Kellerman on what needs mending in the Northeast.

Fortnightly Magazine - August 2006

providing sufficient certainty to attract capital at relatively low cost. By paying the net cost of new entry— capital and operating costs less energy and ancillary services revenues—the FCM will encourage an efficient mix of resources, i.e., demand response, peaking, intermediate, and base-load units.

Because the FCM ties capacity payments directly to performance during periods of system stress and deducts revenues from energy price spikes, generators will be rewarded or penalized based on their actual contributions to reliability.

New England’s “food fight” has morphed into an almost decorous banquet that should serve the region well and can provide a model market for others to emulate.

A Competitive Price

Kellerman correctly focuses on the mismatch between the short-term price signals of most capacity payment schemes and the long-term planning horizon for capacity suppliers. A major flaw in current “demand curve” approaches, like the one adopted by New York’s Independent System Operator (ISO), has been the extreme short-term price signal—usually a matter of only months, not years. Kellerman’s analysis goes awry, however, when he concludes that the best solution is “long-dated, contractually based capacity payment streams.” A viable market should certainly facilitate bilateral contracts, thereby permitting parties to fix their relationship over a longer term, but such contracts need not displace or override the market. Indeed, bilateral arrangements should flow from a stable market structure that encourages long-term planning and commitments.

The FCM goes a long way toward matching price signals with the planning decisions of potential suppliers, thereby facilitating effective competition. The FCM’s primary capacity auction occurs three years before required performance. Thus, although prospective new entrants will have to begin planning and preparation before the auction, they will know three years in advance what their capacity payments will be once they begin operations, and they need not make major capital commitments without that assurance. Moreover, such new entrants can lock in those capacity payments for up to five years, ensuring a predictable revenue stream for their initial operations. Inefficient existing generators can take advantage of this same opportunity for certainty and stability if they undertake substantial upgrades that qualify them as “new” for auction purposes.

Such advance procurement that facilitates new entry should ensure effective competition that will discipline price. In most years, when new capacity is needed to serve load growth, new entrants will set the price based on competitive auction bids—a true market-driven price. During a capacity surplus, existing generators will set the price based on their average variable costs. The most expensive, least efficient generators will drop out of the descending clock auction when their average variable costs exceed the offered price, and they can retire. Over the long term, the capacity price should vary only slightly around the competitively derived net cost of new entry.

The Fallacy of Pay-As-Bid Capacity Pricing

Kellerman has fallen for the seductive allure of hoped-for lower capacity costs if customers only had to pay suppliers’ bids—usually lower than the single market-clearing price. Why should bidders who are willing to supply capacity at $5.00/kW-month be paid the clearing price of $10.00/kW-month simply because