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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

with load-serving responsibilities, a portfolio of merchant generation, and sufficiently strong balance sheets to finance the needed investments.

It’s possible, however, that merchant investors remain wary of market volatility and vulnerability to regulatory intervention, in which case more long-term contracting will be needed. In that case, some load-serving entities will also be interested in procuring more of their resources under long-term contracts or by owning physical generation to hedge the price uncertainty. Yet several secondary factors could still create barriers to long-term contracting, such as the structure of default service procurement in retail access states. If these barriers turn out to be significant—which is difficult to determine under current market conditions—modifying how default service procurement is regulated at the state level may be the most effective way to address these barriers.

If merchant investment and long-term contracting are both impeded even as market fundamentals become tighter—which isn’t yet evident—it might be worth considering policy options to force long-term contracting. One option would be for RTOs to add longer-term procurement to the current capacity market designs. Such decisions shouldn’t be made prematurely, however, because it shouldn’t be the role of an RTO to force long-term contracting for capacity resources when load-serving entities don’t see the risk management benefit of entering into such contracts bilaterally. Nor would an RTO be able to readily determine the amount of long-term contracting or contract terms that optimally balance risks. Mandating too much long-term contracting would inefficiently expose suppliers to delivery and credit risks, while exposing buyers to larger risk premiums and the potential for stranded costs.

 

Endnotes:

1. Pfeifenberger, Newell, Spees, Hajos and Madjarov, “Second Performance Assessment of PJM’s Reliability Pricing Model,” Aug. 26, 2011.

2. See also letters from Credit Agricole and Union Bank attached to LS Power Associate Comments on New Jersey Electric Power and Capacity Needs, Submitted in State of New Jersey Board of Public Utilities, Docket No. EO 09110920, July 2, 2011.

3. Approximate procurement prices were calculated in “Comments of the New Jersey Electric Distribution Companies on Agent’s March 21, 2011 Report,” March 24, 2011.

4. See also B. Chin, “Capacity Issues Technical Conference: State of New Jersey,” Citi Investment Research, June 24, 2010, noting that “in our view, energy/capacity markets are providing a signal that capital shouldn’t be deployed to [new] generation at this time, unless subsidies are enacted.”

5. See Constellation’s 2010 10-K filing, Part 1, Item 1, pp. 4-5.

6. “Constellation Energy Signs Agreement to Acquire the 2,950 MW Boston Generating Gas Fleet in New England,” Constellation Press Release, August 9, 2010.

7. “Direct Energy Corporate Fact Sheet.” May 2011.

8. Megawatt Daily, “NRG to buy Energy Plus Holdings for $190 mil,” Aug. 17, 2011.

9. Kiesling and Kleit (2009), Electricity Restructuring: The Texas Story, Chapter 8, AEI Press, Washington, D.C.

10. The use of balance sheet financing doesn’t mean that medium- or long-term contracts are eliminated for these projects. Rather, it simply means that the role of medium or long-term contracts is reduced because at least some projects can be built with less of the project costs