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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

12 Similarly, generation owners are integrating vertically into retail sales, as noted in the above discussion of NRG, Constellation, and Direct Energy, and with Exelon’s proposed merger with Constellation as another recent example.

A transition to a partially integrated industry structure has a number of potential advantages and will reduce the need for, or compensate for the lack of, extensive bilateral contracting. 13 Competition will be maintained or enhanced because the companies have a reduced ability and incentive to exercise market power and, unlike in non-restructured markets, aren’t fully integrated and don’t enjoy exclusive service franchises. 14

Consistent with these observations, the deregulated electricity industry likely will migrate naturally to a partially vertically integrated structure that, over time, will rely less on long-term PPAs to underwrite new generation development. These trends reflect an efficient response to deregulation, which shifts the risks of potentially uneconomic generation investments away from customers and toward developers. As increasingly large and diversified companies, these developers will be in a better position to evaluate, manage, and bear these risks. Regulatory or legislative intervention to force long-term contracting in restructured markets—even if accomplished via the typical capacity market design—carries with it the risk of interfering with the natural evolution of the industry and threatening adverse long-term consequences for future capacity expansion.

Market Fundamentals

There may be many generation projects that can’t get financed and built under current market conditions. However, while some project developers might cast this as a market failure caused by the inadequacies of capacity markets or state retail choice constructs, the primary reason that these projects can’t get financed and built is that they are currently uncompetitive with alternative sources of capacity.

The main reason for the low activity of new power plant construction in eastern PJM, for example, is the fact that new plants haven’t been needed—and won’t be needed for several more years—due to a combination of economy-related decreases in load growth, transmission upgrades, and the availability of lower-cost supply options, such as deferred retirements, demand response, and upgrades to existing units. In fact, PJM’s capacity market has successfully ensured resource adequacy at prices below the cost of new plants. In other words, the lack of long-term contracts for new generation is explained by market fundamentals and the simple fact that new plants have been out of the money.

These market fundamentals also explain the lack of long-term contract offers from existing generation. Suppliers of existing capacity are unwilling to enter long-term contracts at low current prices because they expect prices will rise. At the same time, buyers are unwilling to pay higher prices or even the cost of new generation when there are less expensive options currently available in the market.

When new plants are needed for resource adequacy, capacity market prices will rise and will make these investments attractive—both on a merchant and long-term contracting basis. It’s likely that the need for and reliance on very long-term PPAs and project financing ultimately will diminish as the industry evolves and an increasing share of new plants are developed by larger, partially vertically-integrated companies