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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

Capacity markets were implemented in a number of restructured power markets to meet resource adequacy requirements through a market-based solution. However, after several years of experience with capacity markets, their performance is questioned by many market participants.

While Brattle Group’s recent review of PJM’s capacity market, the Reliability Pricing Model or “RPM,” concludes that the market is performing very well, discussions with a number of stakeholders reveal considerable doubt that capacity markets can support new generation investments. 1 The general concern is that prices are too uncertain because capacity auctions establish the price only for one year at a time, and buyers aren’t willing to sign long-term contracts bilaterally. However, different stakeholders also offer different perspectives.

State regulators in eastern PJM express the concern that after several years of operation and high prices, the capacity market hasn’t led to significant new construction of power plants. Regulators and a number of market participants also point to a lack of long-term contracting that could support the financing of new generation additions in eastern PJM. Some of the generation developers specifically note that the three-year forward capacity prices under PJM, which are locked in for only one delivery year at a time, can’t support the financing of new generation projects. They suggest that prices would need to be locked in for 10 years or more to support financing of new generation projects, a notion that’s echoed by some financial industry participants. 2 They also stress that buyers are unwilling to enter into longer-term contracts.

Public power companies, such as cooperative utilities, indicate a strong interest in signing long-term contracts, but note that they’ve been unable to find willing suppliers. Stakeholders agree that long-term bilateral contracting currently isn’t available for more than the next three to five years.

The regulators’ and generators’ concern that an absence of long-term bilateral contracts undermines the financing of new plants seems inconsistent with public power stakeholders’ concern that suppliers have been generally unwilling to offer such long-term contracts. This apparent inconsistency, however, is explained largely by current market fundamentals and economic conditions that haven’t justified the addition of new generating capacity.

That means it’s premature to conclude that capacity markets need major changes to support new investment; merchant generation investment and longer-term contracting are likely to reemerge when market fundamentals support the addition of new generating resources.

The Role of Market Fundamentals

Relatively few new power plants have been built in eastern PJM since RPM has been implemented. However, that doesn’t mean no new resources have been added in eastern PJM. Since 2007, capacity uprates of existing plants (2,210 MW), reactivations

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