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The High Cost of "Free" Capacity

Fickle behavior by LSEs threatens to destabilize organized markets.

Fortnightly Magazine - May 2008

if Duquesne’s departure proves beneficial to ratepayers, there is still a free-rider problem that threatens the RTO’s resource-adequacy construct.

Reliability is a public good. LSEs should not be able to capture the benefits of increased RTO reliability and then opportunistically withdraw when there is excess local capacity. Reliability for one is reliability for all, and decisions made by individuals affect others. Left on their own, market participants won’t provide enough system reliability, because they can’t reap the full economic benefits of doing so and would rather free-ride on the investments made by their neighbors.

Markets for adequacy won’t deliver the expected services in the absence of a long-term commitment by LSEs—either through long-term capacity purchases or, at the very least, a commitment to stay in the RTO and buy capacity in the future at spot market prices.

To guarantee the sustainability of complex and ever-changing electric grids, RTOs engage in long-term regional planning and force LSEs to secure the capacity in support of their load—similar to the way governments force workers to contribute toward their retirement so their lack of savings doesn’t later turn into a social problem. Because of the public-good nature of system reliability, RTOs must impose obligations on LSEs to prevent behaviors that negatively affect the entire system.

But RTOs’ planning efforts will be futile if they must design rules intended to keep all parties happy all the time— i.e., so no one is ever tempted to leave to capture short-term profits in neighboring areas. Through iron-in-the-ground facilities, investors make long-term commitments to RTOs, even as they are able to sell power into different markets. LSEs, on the other hand, can opt for different market rules by withdrawing from regional systems. The result is an unpredictable market for investment.

A more subtle, but equally detrimental market outcome arises when, after reliability markets are designed, LSEs exercise buyer-side power (also known as monopsony power) to depress competitive prices. Although FERC is addressing this problem in an investigation into NYISO’s installed capacity (ICAP) market rules for the New York City zone, to date there has not been a fundamental analysis of buyer-side market power in reliability markets.

Buyer-side market power works like this: Typically, capacity markets have only a handful of buyers, mostly local LSEs. Thus if LSEs can manage to depress capacity prices, even at a high cost, they will capture a large share of the benefits. For example, by repowering an obsolete plant or building facilities where they are not needed (or justified by their own revenues), LSEs can lower the price they pay for all their capacity purchases. Just as dominant suppliers profitably can increase prices by withholding capacity, large buyers artificially can depress prices by overbuilding (or over-contracting).

An example clarifies this point. Suppose a hypothetical capacity market clears at $10 per kW-month, but the replacement cost of a peaking plant, after incorporating a fair return on investment, taxes, etc. , is perceived by investors to be $20/kW-mo. A merchant supplier almost certainly would not undertake the project. However, a utility that has to purchase 1,000