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The High Cost of "Free" Capacity

Fickle behavior by LSEs threatens to destabilize organized markets.

Fortnightly Magazine - May 2008

end results from state prudence reviews can expose utilities to rate disallowances if subsequent price changes make the contracts unattractive.

Unless LSEs compensate generators for the financial obligations they incur, the FPO effectively will impose a price cap on LSEs equal to the generation cost of a peaking unit. Those price caps suppress legitimate price signals—specifically, the price signals that LMPs are meant to provide. To make matters worse, these price caps lead to asymmetric regulation. Like a “heads I win, tails you lose” proposition, high prices are capped at generation costs, but there is no downside protection.

In sum, long-term contracts attached to capacity payments might foster the development of wholesale markets. But if sellers and customers consider such contracts to be disadvantageous, they may instead turn to the spot energy market and avoid them altogether. This only will exacerbate reliability problems.

Reliability Will Suffer

The fate of installed-capacity markets will define the long-term viability of competitive wholesale electricity markets in the United States. Capacity markets are instrumental in reducing the risks from volatile energy markets. New generation investments, spurred by capacity revenues, also will increase competition in energy markets. Furthermore, when prices are high, capacity markets have the potential to hedge against the inevitable regulatory and political pressures for energy market intervention. The result will be lower energy prices and improved reliability.

Despite some headlines, regional integration of competitive wholesale markets has been successful, especially in markets in the eastern United States. Regional integration is, however, a work in progress and may not be delivering benefits as fast as customers expected. Even so, returning to traditional utility regulation, either by leaving well-functioning RTOs or by imposing cost-of-service style rate obligations on suppliers, carries the risk of impeding a rational resolution of reliability problems. Even worse, the continuous threat that comes from ignoring long-term commitments and working the political process for transitory benefits deters new generation investors. The result will be higher electric prices and reduced reliability.



1. 20filing%20011608.pdf

2. Notice of Proposed Rulemaking, “Wholesale Competition in Regions with Organized Electric Markets,” 122 FERC ¶ 61,167.

3. Consumers’ Supplemental Comments and Proposed Alternative Market Model, Docket Nos. RM07-19-000 and AD07-7-000, January 11, 2008.

4. Stigler, George J., Memoirs of an Unregulated Economist , University of Chicago Press, 2003.

5. Stigler, George J. and Friedland, Claire, “What Can Regulators Regulate? The Case of Electricity,” Journal of Law and Economics 5 (1962): 1–16.

6. For a broader discussion of the public good aspect of reliability, see Lesser, Jonathan A. and Israilevich, Guillermo, “ The Capacity Market Enigma ,” Public Utilities Fortnightly , December 2005: 38-42.

7. FERC Docket No. EL07-39-000.

8. See “An Act Concerning Energy Independence,” Conn. Public Act 05-01 (H.B. No. 7501), 2005.

9. For a discussion of the prudent investment standard in energy regulation, see Lesser, Jonathan A. and Giacchino, Leonardo R., “Cost Measurement,” in Fundamentals of Energy Regulation, ch. 5, Public Utilities Reports Inc. , Vienna, Va., 2007.

10. The benefits of capacity markets are not just a theoretical construct. Early restructured markets in South America