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Trusting Capacity Markets

Does the lack of long-term pricing undermine the financing of new power plants?

Fortnightly Magazine - December 2011

(360 MW), export reductions (930 MW), increased demand response (6,550 MW), and approximately 2,040 MW of new generation capacity has been committed through RPM in eastern PJM. And another 650 MW of new generation offers have been submitted but failed to clear because sufficient capacity was offered at prices below the cost of new generation.

The relatively modest level of new generation construction in eastern PJM hasn’t led to resource adequacy shortfalls, as some stakeholders believe. Rather, reserve margins have remained at or above target levels due to the combination of entry by these new generation units, demand response resources, upgrades to existing capacity, deferred retirements, planned transmission upgrades, and the economic slowdown. Moreover, RPM has maintained resource adequacy at prices that are generally below the cost of new generating plants.

State regulators are correct that market prices for capacity in eastern PJM have been significantly higher than in the remainder of PJM in most of the recent capacity auctions. However, even the higher eastern PJM capacity prices have generally remained below the cost of new plants. Prices will remain below the cost of new plants until new generation is needed and capacity prices rise to clear new offers.

The underlying fact under these market fundamentals is that new generation simply isn’t cost-competitive with lower-cost options—such as uprates, deferred retirements, and demand response. That’s likely the primary reason why more new generating plants haven’t been built in eastern PJM. That capacity prices will remain below the cost of new plants through 2015 and possibly for several more years is likely also the primary reason that some developers’ new generation projects can’t be financed without long-term contracts that cover project costs. Current market conditions simply don’t support long-term contracts at prices high enough to finance new plants because rational buyers prefer to satisfy their capacity requirements at market prices that are below the contract cost of a new plant.

Under these market conditions, when few or no new plants are needed, the only way to finance additional new generation would be through above-market long-term contracts. Such above-market contracts have recently been offered through a legislative mandate, which procured capacity for three new plants under fixed-price 15-year contracts whose costs aren’t public but that are estimated at $270 to $350 per MW-day. 3 In comparison, RPM prices in have been much lower at $136 to $225/MW-day in PJM’s most recent capacity auction. Nevertheless, in October 2011, the utilities similarly issued RFPs for new generation under direction of the Maryland PSC.

In short, the lack of long-term contracts and financing for new plant construction is a consequence of the fact that investments in new generation are currently unprofitable and not a least-cost option to ensure resource adequacy. Under these circumstances, a well-functioning market won’t reward investments in new generation. The absence of new construction is a sign that the market is working.

Current market fundamentals are also the likely reason that public power entities looking for long-term capacity contracts haven’t found willing suppliers. First, given that capacity prices might remain below the cost of new plants