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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

the last increment of capacity needed could only be purchased at that price? Unfortunately, waving a wand cannot alter economic realities, and attempts to implement such sleight of hand almost certainly will backfire.

For more than 50 years (beginning with Marcel Boiteux in a seminal 1949 article on marginal cost-based peak-load pricing), economists have shown that a least-cost electricity system includes a mix of types of generating plants with varying capital and operating costs but the same incremental capacity cost. For example, although a gas-turbine peaking unit has lower capital costs than a base-load coal plant, it also has higher operating costs, and the residual cost of capacity for the two plants will be the same. Bidwell (the co-author of this article) explains and demonstrates this relationship. Thus, in a least-cost system, a single incremental capacity cost paid to all generators will provide each generator with the same prospective return on capital investment. When it would reduce system costs to build a particular type of plant, the expected return for that plant under a market-clearing price approach will be greater than the expected return for any other type plant, thus providing market incentives to optimize the system.

Moreover, the real world will not operate as Kellerman supposes. The lower-cost generator will not continue to bid $5.00/kW-month when others receive twice as much for the same commodity. Rather, it will alter its bidding strategies and attempt to guess the highest bid that must be accepted to supply sufficient capacity for reliability. If all bidders guess correctly, the resulting capacity cost for consumers will be the same, and nothing will be gained. With multiple suppliers, however, some likely will overestimate the market-clearing price, meaning that lower-marginal cost bids may be rejected in favor of higher-marginal cost suppliers. As Alfred Kahn showed (“Uniform Pricing or Pay-as-Bid Pricing: A Dilemma for California and Beyond,” The Electricity Journal, July 2001) , customers will bear the costs of such inefficiencies. The FCM, like all efficient commodity markets, pays all successful bidders the same price, and the Federal Energy Regulatory Commission (FERC) has promoted this market design uniformly (see Commonwealth Edison Co., 113 FERC ¶ 61,278 [2005] at P 43; Midwest Independent Transmission System Operator, Inc., 102 FERC ¶ 61,196 [2003] at P 32) .

Purchase Only the Capacity Needed

Kellerman’s plea for “delineation of who is responsible for capacity reliability” has some validity. Although FERC has asserted an ever-expanding role, it acknowledges that states have traditionally been the guardians of capacity reliability. State political bodies are best positioned to weigh the costs of excess capacity against the reliability risk of running short. Nevertheless, FERC has tasked regional transmission organizations (RTOs) like ISO New England with at least initial responsibility for planning to meet capacity reliability commitments in each geographic area. RTOs cannot reasonably make those decisions in a vacuum, however, and states, particularly, should have the primary voice.

Most of the RTOs’ capacity market proposals would require customers to pay for more reliability than required to meet the accepted loss-of-load expectation of one day in 10 years. Those