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The High Cost of "Free" Capacity

Fickle behavior by LSEs threatens to destabilize organized markets.

Fortnightly Magazine - May 2008

MW of capacity in the market at $10/kW-mo might find it profitable to build a 100-MW facility, even though its construction cost is $20/kW-mo, if, by doing so it reduces capacity prices to $5/kW-mo. The $10/kW-mo losses for the 100-MW plant pale in comparison to the $5/kW-mo of savings for the remaining 900 MW the utility had to purchase in the market (see Figure 1) .

The irony is that such an LSE actually might get unconditional support from policymakers because it appears to be making sacrifices to build new capacity, lower rates and, of course, create new jobs. One such proposal—explicitly aimed at reducing capacity charges—was passed by the Connecticut state legislature in July 2005. This proposal authorized and encouraged utilities that previously divested their generation assets to purchase and own new generation. However, capacity isn’t being built because of its own merits. As shown in the example above, the utility might have the incentive to build a plant that costs more than what it’s worth in the market, because it artificially lowers market clearing prices. In this situation, prospective investors will perceive market rules as unfair, and no investments will be made—apart from those of vertically integrated utilities.

Contracts vs. Regulation

The AF&PA proposal for financial performance obligations (FPOs) contains some innovative features that—if properly implemented—have the potential to contribute to the liquidity of energy markets.

FPOs would require suppliers that receive capacity payments to financially guarantee the delivery of energy at or below a specified strike price. The strike price would equal the variable cost of the peaking unit used as a benchmark for the capacity payments. The FPO basically has two components: 1) the capacity payment as seen in some organized RTOs; and 2) a mandatory contract to sell energy at or below a strike price. The free-lunch component of the FPO is that it does not incorporate any direct compensation for the energy contract and its associated risk. But this can be corrected by pricing such a contract in the capacity auction. Then, long-term energy contracts could be jointly negotiated with capacity commitments in an organized market with standardized products, rather than through bilateral contracts. Creating markets, however, is difficult. Ill-defined contracts create perverse incentives, because returns are not commensurate with the risks imposed on participants— e.g., because of apparent free lunches.

Rather than creating a mechanism that encourages long-term contracting, the proposed FPO would impose those contracts without also providing any direct compensation for the associated risk. Thus, the FPO will discourage generators from bidding their capacity into the market. The FPO also will encourage suppliers to delist their capacity resources, especially in constrained areas where new capacity is most needed. This perverse incentive is embedded in the obligation to sell energy at the strike price which, everything else being the same, represents a greater financial risk in high-LMP areas. Mandatory long-term contracts also might turn LSEs away from capacity markets, because the contracts force LSEs into long energy positions that are not welcomed by rating agencies and capital markets. In addition, the focus on