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Capacity Markets: Efficient As Buying a 40-Year Clunker The ERCOT Independent Market Monitor has released the 2012 State of the Market Report, and the report spends considerable time defending capacity markets as "efficient."
While we might not dispute capacity markets are the most "efficient" manner to meet some administratively determined fiat, we don't understand how capacity markets can in any way be called efficient in terms of the bottom line, which is providing customers with the most efficient electricity rate (which in a competitive market is the lowest cost outcome).
The conclusion that capacity markets are efficient is especially surprising given the IMM's acknowledgement that co-optimization (of energy and reserves) is needed for the most efficient market outcomes.
Capacity markets, of course, destroy the efficiencies of co-optimization by procuring your resource base three-years ahead of time (under the PJM model sought for ERCOT), without taking into consideration the variable costs of energy and ancillaries production in the delivery year. The resources with the lowest variable costs (and thus lowest energy prices) might not be the resources with the lowest going-forward fixed costs, which are the resources which clear the capacity market first.
In fact, older units, which are generally much less efficient, are generally those units which clear the capacity market first, because they are largely depreciated. New entrants, using the latest and most efficient technology to lower the variable costs of energy production, are going to be challenged to clear the capacity market, especially if they are forbidden from bidding in at $0 or some other low capacity price, which reflects their expectations of future energy market revenues (and thus reduced need to recover all fixed costs through capacity payments), because such low capacity offers by new resources are deemed, by government regulators, to be "uncompetitive."
This can all be simplified by thinking about buying a car. There's an upfront cost (the capacity market), and then the ongoing costs of ownership (variable energy production costs)
If you just want to buy the cheapest *car* available, you'd probably end up with some 40-year clunker, with 200,000 miles on the clock, and gas mileage of 12/mpg, for less than $500. However, when customers buy a car, what they are really buying is transportation and mobility, and thus the fixed cost of the automobile is not the only consideration; customers take into account variable costs (such as gas) and cost of ownership.
Therefore, most rational people bypass the 40-year clunker, even though it might only be $500. They know that, in the long-run, from a total cost of ownership, they will be better off with something more efficient, that maybe gets 25-30/mpg, and are willing to pay higher fixed costs upfront, in fact, 30 to 40 times higher, for lower future variable costs.
The electricity market should be thought of the same way. Customers don't pay for capacity, energy, and ancillaries, they pay for electricity, holistically. They don't care if the capacity market clears the absolutely cheapest resources from an administrative capacity-product perspective if it means they're going to be throwing money down the drain by relying on inefficient steam units in the energy market, which is like driving a 40-year old gas guzzler.
If there was a capacity market for cars, and it was like the electric capacity markets, we'd all be driving 1973 Oldsmobile Vista Cruisers, not Toyota Corollas and Honda Civics, and certainly not the really innovative (but higher fixed cost) products like the Prius, Volt, etc.
Of course, a capacity market doesn't legally prevent new, more efficient entrants from entering the market if they don't clear the capacity market; however, if you believe the spin put out by capacity market supporters, you will never see new generation that is not receiving a capacity payment, because:
1. Investors won't invest on uncertain energy-only revenues, and
2. The capacity market is going to reduce volatility and scarcity in the energy market -- meaning any new resource without a capacity payment is not going to be able to recover its fixed costs through scarcity pricing in the energy market.
Therefore, it's the capacity market, not the energy-only market, which is going to give Texas a fleet of 50-year old generating assets. The capacity market props up the life of these clunkers by creating a market where they have an advantage due to their age -- low going forward fixed costs. As has been noted previously by Matters, this is exactly what happened in PJM.
In contrast, ERCOT's energy-only market actually brings new, efficient resources to market, because without the capacity market subsidizing incumbent assets, new, more efficient generators can put older plants out of business. Indeed, we have heard before capacity market supporters say that this is one of the reasons ERCOT is in the precarious position from a resource adequacy perspective -- the energy market has driven so much efficiency in the dispatch stack that all the really expensive relic steam units are gone (or used only at super-peaks), and therefore, there's no more real spark spread for the next new unit to come in and take advantage of, in order to beat the current clearing price. We don't think the solution to this problem is to introduce more inefficiency into the market.
As to the 2012 State of the Market Report, which is available here the report unsurprisingly concludes net revenue in 2012 was insufficient to support new entry, as is appropriate given there was a sufficient reserve margin last year.
We expect there to be a lot of harping on this by capacity market supporters, but we remind them that, in their own words, investors don't rely on past energy-only market prices when they make their decisions, so the 2012 results should be taken with a grain of salt, under their own reasoning.
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June 21, 2013
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Copyright 2010-13 EnergyChoiceMatters.com
Reporting by Paul Ring • ring@energychoicematters.com
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