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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

approaches purport to justify buying more capacity than necessary because they expect wide price fluctuations that will lead to less capacity than needed in some years, followed by oversupply in other years. This predestined vacillation above and below the norm led some RTO market designers to err on the side of too much reliability and require customers to pay for as much as 5 percent more capacity than they need.

The FCM avoids this profligacy by procuring only the capacity actually required to meet technical reliability criteria. By requiring retiring generators to announce their intentions well in advance, purchasing replacement capacity three years ahead, and extracting enforceable performance commitments from suppliers, the RTO-administered auction can buy 100 percent of installed capacity requirements for the region, and no more. Small deficiencies due to underestimation of load growth, or suppliers that default, can be made up in annual reconfiguration auctions (where suppliers can also adjust their positions). Reliability is ensured, but customers are not compelled to over-buy based on a purely administrative determination.

Customers Get What They Pay For

Kellerman properly faults existing capacity procurement approaches for failing to deliver on their promise to stimulate new capacity. High prices appear to be sending strong signals to build new capacity, but no one responds. This brush off from capacity investors is not surprising when market signals are short-term and likely will be ephemeral once an unwary supplier comes on line, thereby lowering the capacity price. By locking in capacity suppliers three years before their commitment, with material penalties for non-performance, the FCM ensures that capacity payments actually produce the intended level of reliability.

The FCM goes a step further, however, and pays only those generators that show up when the ISO calls on them. Capacity payments that are not tied directly to performance are money down the drain. Under the FCM, poor performers will be docked and good performers rewarded in two respects. First, generators that are unavailable for any reason during capacity shortage periods will forfeit a significant part of their capacity payments. To add insult to injury, the forfeited capacity payments will be distributed among the good performers— i.e., to the unavailable generator’s competitors. Second, capacity payments will be reduced for all resources when energy revenues exceed a relatively high strike price. Resources that miss the spike prices when capacity is scarce still will have their capacity payments cut, but cannot offset that reduction with earned energy revenues. These provisions create strong financial incentives for suppliers to improve reliability and availability, consequently reducing the need for new capacity to cover peak loads. The FCM accomplishes on a system-wide basis what would be difficult to achieve through bilateral contracting alone: improved reliability performance for the entire market.

Why Settle For Second, Or Third, Best?

No other capacity procurement model provides the benefits of the FCM. First, unlike a rigid, centrally controlled capacity procurement approach that must specially accommodate nontraditional applications, the FCM stimulates innovative participation from all potential capacity resources. Demand, distributed, intermittent, and import resources all fit neatly within the FCM auctions