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The High Cost of "Free" Capacity

Fickle behavior by LSEs threatens to destabilize organized markets.

Fortnightly Magazine - May 2008

virtually every RTO/ISO in which representatives of consumers and LSEs have rejected any sort of capacity payment or demanded that energy markets be capped in exchange for such payments.

The economic fallacy in these proposals stems from an underlying assumption that consumers will obtain lower rates if investors are forced to sell some power services at competitive rates while supplying other services for free.

No Free Lunch

Economist George Stigler once wrote that economic logic is encapsulated in the phrase, “There’s no such thing as a free lunch.” As the only person who won a Nobel Prize for analyzing causes and effects of public regulation, Stigler found as early as 1962 that state regulation had no important effect on electricity prices during the early twentieth century. Stigler’s observation seems to be borne out by recent events that suggest factors other than economic policy are prime movers when it comes to public utility regulation.

Duquesne’s decision to withdraw from PJM probably won’t lead to a slippery slope in which members increasingly withdraw from their RTOs. However, its departure does raise a more fundamental policy challenge for RTOs that plan to address long-term reliability through a market-based approach.

Just as suppliers can offer capacity in different markets, LSEs should have, in principle, the same right to shop for RTOs that best represent their ratepayers’ interests. However, the long-term nature of resource adequacy and capacity markets presents a set of more complex challenges.

For example, to exploit economies of scale, base-load plants tend to be large. In a transmission-constrained region, this creates a problem, because large plants may have a disproportionate impact on market-clearing prices and overall system reliability. They also require investors to commit more capital in a single facility with a long construction time. Capacity markets are meant to provide potential investors with a stable and predictable stream of revenues. Forward auctions go a step further and create a contractual agreement that allows investors to obtain financing for the development or renovation of generation capacity.

A forward commitment is necessary to secure demand-response programs and generation resources sufficient to maintain a reliable system in the future. So when LSEs opt out from a market construct in order to avoid capacity charges, they leave investors stranded. Suppliers are less likely to invest in projects for the long term if they feel the rules of the market will change or key customers will stay only if prices turn out to be sufficiently low.

The Dark Side

Duquesne is leaving the world’s largest competitive wholesale market and one of the most reliable grids to join a market that is under development. The main advantage of doing this is that MISO is operating at a high reserve margin and thus capacity can be secured at bargain prices. However, Duquesne’s comparison of short-term capacity prices between PJM and MISO may turn out to be myopic and against ratepayers’ interests. Although politically tempting (because it might keep rates low for a while), Duquesne’s strategy postpones proper long-term resource planning and might expose ratepayers to volatile energy markets.

But even