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The Value of Resource Adequacy

Why reserve margins aren’t just about keeping the lights on.

Fortnightly Magazine - March 2011

0.5 percentage points.

Importantly, as Figure 1 illustrates, because the cost of reliability events (in particular emergency and reliability purchases) increases quickly as reserve margins decline, omitting some of these costs in reserve margin evaluations can lead to greatly understated estimates of optimal reserve margins. If one considered only the installed cost of peaking capacity and the value of lost load, the reserve margin that yields the lowest average costs would appear to be only 9 percent, while it’s 12 percent when all reliability-related costs are considered—and before even attributing any insurance value to risk mitigation.

Finally, Figure 1 also shows the strikingly different reserve margins that would result from applying the 1-in-10 standard interpreted as 1) 2.4 hours of lost load per year and 2) 1 event in 10 years. These different interpretations of the 1-in-10 standard yield a difference in the target reserve margin of 4.5 percentage points.

Risk-Adjusted Reserve Margins

In the presence of risk aversion, the value of higher reserve margins also includes the insurance value of avoiding infrequent high-cost outcomes. While Figure 1 is informative, it over-simplifies the problem by only comparing fixed capacity costs with the long-term averages of very uncertain market exposures. To perform a more informed comparison, the uncertainty of market exposure needs to be considered as well.

The probability distributions of the total annual costs (excluding the more certain CT carrying costs) are shown in Figure 2. The figure shows that substantial annual cost uncertainty exists at any given level of reserve margin. Most of this cost uncertainty is associated with the risk of very infrequent high-cost outcomes.

As Figure 2 shows, for 90 percent of possible annual outcomes, the reliability-related cost exposure is quite low for reserve margins in the 11 percent to 18 percent range. Only in the last 10 percent of possible annual outcomes does a combination of factors occur that causes substantial reliability-related costs. For example, while the expected average of annual reliability-related costs at a 12 percent reserve margin are only $240 million, there is a very small chance that total annual reliability-related costs could be as high as $8.3 billion. Assuming total retail rates are 10 cents/kWh, this maximum cost exposure would raise consumers’ annual costs by 50 percent. These numbers are not unrealistic considering that the California Energy Crisis would have doubled retail rates if all costs had been passed through to customers.

Considering that customers, regulators, and policy makers want to avoid high-cost outcomes, the “optimal” target reserve margin consequently shouldn’t be based solely on the lowest-average cost reserve margin, shown as 12 percent in Figure 1. While a 12 percent reserve margin would offer the cheapest option for customers in terms of long-run average costs, the highest-cost outcomes that load serving entities and customers would be exposed to might be unacceptable.

In the insurance industry, premiums are frequently set using a 95 percent confidence level that the insurance company will be covered in the long term. A similar calculation for determining the appropriate risk adjustment can be used for setting the target reserve margin. Assuming that