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Capacity Markets: Encouraging Gold-Plating of the Electric System Centralized capacity markets -- specifically those with a downward sloping demand curve -- are reintroducing into the electric industry one of the main catalysts of deregulation -- the gold-plating of the electric system.
BREAKING: Direct Energy to Acquire Texas Specifically, one of the principal drivers of electric restructuring was that the prior cost-plus regulation encouraged excessive construction of assets (gold plating), since monopoly franchise holders earned their returns on such assets and therefore they recommended construction of such assets even when not necessary to fulfill their responsibility to adequately serve customers.
Although restructuring has also encouraged efficiencies in the operation of needed resources, one of the largest drivers of cost savings under deregulation has been the elimination of ratepayer support for unnecessary generation assets -- those not supported by the market, and not needed under any objective reliability standard. In other words, the elimination of gold-plating.
However, capacity markets, specifically those with the "downward sloping demand curve" sought by generators (and all too often so-called economists), essentially return the electric industry to the "bad old days" of gold-plating.
We are reminded of this by the recently released State of the Market report from the Midwest ISO Independent Market Monitor, which recommends the introduction of a downward sloping demand curve in the MISO capacity market. The MISO capacity market currently uses what is, essentially, a vertical demand curve, which simply buys capacity in the amount needed to meet the minimum reserve margin. Matters would note that the MISO IMM is Potomac Economics, which serves as the IMM in ERCOT as well.
What does a downward sloping demand curve do? Essentially, instead of procuring capacity just to meet the objective reliability standard as expressed in a reserve margin (say 15%), the operation of the sloped demand curve, in order to reduce volatility in year-to-year capacity prices, may procure capacity in excess of the capacity needed to meet the "mandated" reserve margin.
This is simply gold-plating by another name -- paying for assets that are not needed.
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ADVERTISEMENT The MISO IMM, as other economists in support of the downward sloping demand curve have done, argues that the procurement of (and payment by customers for), excess capacity (in reality, excess, excess capacity, since the reserve margin itself is already excess capacity above the forecast demand) is appropriate because customers receive some sort of "value" from procuring the additional excess capacity, which, by definition, is not needed to meet the objective reliability standard which was used to set the mandated reserve margin.
The value is, allegedly, that procuring extra, extra capacity further decreases the risk of resource inadequacy, and therefore, it's "efficient" to compel load to purchase this capacity, even though it is not needed.
As an aside, we'll note that if you buy this argument, it utterly destroys the notion that the reserve margin provides any assurance against blackouts (the argument currently being advanced in Texas), because how could buying additional capacity provide "value" if simply meeting the mandated reserve margin already assured customers that they would have resource adequacy?
The "value" from purchasing capacity in excess of the reserve margin can only arise if procuring capacity at exactly the reserve margin still leaves the potential for resource inadequacy, which is, in fact (we agree), the case (due to black-swan type events outside the normal 1 in 10 years standard). However, if that's the case, the whole notion of mandating any reserve margin must be seriously questioned, because where does it stop? A 20% reserve margin will be "safer" than 15% ... 25% will be even more safe. Why not a 50% reserve margin? Where does it end (and why should government be making this decision?)
In any case, back to our downward sloping demand curve. No matter how economists try to spin it, purchases in excess of the reserve margin are, by definition, not needed to meet the reserve margin. The value that customers get from their mandated capacity is to meet the mandated reserve margin. Period.
Any capacity purchased in excess of the mandated reserve margin is, by definition, superfluous, and therefore, of zero value to customers. The excess capacity may present some intangible, commons-type reliability benefit, but it is of no concern to load, which is only engaged in the capacity market to meet the minimum reserve margin, NOT to assure some other, arbitrary, and gradient reliability metric.
In 2011 comments to FERC on the need for a sloped demand curve, the MISO IMM states:
"The demand for any good is determined by the value the buyer derives from the good."
So far so good.
"For capacity, the value is derived from the reliability provided by the capacity to electricity consumers."
This is where the argument falls off the rails. Again, the value is not the reliability value, but rather the value in meeting a mandated reserve margin. Absent this government fiat, customers would NOT be purchasing capacity (relying instead on economic incentives in the energy market to assure resource adequacy, since assets wishing to earn margin could only do so by being available, thereby obviating the need for a forward capacity payment as an "incentive" to be available)
In the recent MISO state of the market report, the MISO IMM specifically states that:
"The implication of the vertical demand curve is that the last MW of capacity needed to satisfy the minimum requirement has a value equal to the deficiency price, while the first MW of surplus has no value. This is not true in reality -- each unit of surplus capacity will improve reliability and lower energy and ancillary services costs for consumers (although these effects diminish as the surplus increases)."
We addressed the "reliability" argument above. Although we will emphasize one additional point -- the "reliability value" argument in justifying the purchase of excess capacity under a sloped demand curve is the same argument that was being made by the old monopoly utilities seeking to justify gold-plating during the "bad old days" of regulation -- sure building this unnecessary generating asset would cost more, but who cares, it's a good "value" because it is providing an extra safety net (on top of the reserve margin which is already designed to be a sufficient safety net).
We also fail to see how it can be argued paying for excess capacity will decrease energy and ancillary services costs, unless the argument is that the grid will be less likely to enter scarcity conditions with the excess, excess capacity (a strained argument if that is indeed the case, since, again, the reserve margin is already supposed to account for this, and reduce energy market volatility).
"Establishing only a minimum requirement and deficiency charges results in an implicit vertical demand curve for capacity in MISO. This does not reasonably reflect the reliability value of capacity and understates capacity prices as capacity levels fall toward the minimum requirement," the IMM says in the state of the market report.
"A sloped demand curve would more accurately reflect the reliability value of capacity in excess of the minimum requirement. It also will produce more efficient and stable capacity prices, particularly as the market moves toward the minimum planning reserve requirement. If this recommendation is not addressed, the MISO markets will not facilitate efficient investment and retirement decisions by participants that will sustain an adequate resource base," the MISO IMM states.
This "problem" actually reflects efficient pricing, and if investors can't make a "market" mechanism work (one in which load is compelled to purchase capacity, we stress), then the problem isn't with the market, it's with investors, and accordingly, the whole notion of private investment in power generation (i.e. restructuring). Specifically, the claimed problem is that if there is excess capacity above the mandated reserve margin, even in a small amount, prices will crash, because only existing units with low going forward costs are needed, and there is no need for new entry (whose higher costs would buoy all capacity prices in a single clearing price market).
But isn't that what's supposed to happen in a, supposedly, free market (again, we cannot stress enough that demand is artificial in the capacity market). If there's no demand for new entry (e.g. the reserve margin is already met), why should the government force the market to procure extra capacity just to support higher prices to support new entry which isn't needed.
The IMM, in its 2011 FERC filing, opines that the vertical demand curve, "will result in significant volatility and uncertainty for market participants."
Newsflash: Markets are uncertain. Markets are volatile. You'd think Wall Street, of all places, would be familiar with this, but it's always painted as some sort of shock that wasn't expected from restructuring -- "you mean we actually have to put our own capital at risk, with no guarantee of future prices?"
If investors don't want to support market-based generation, we can talk about a return to rate regulation (we believe that is unnecessary, but it is the logical outcome if all this hand-wringing about volatile prices and uncertainty is to be believed). But don't give us this hybrid, administrative "market" where generators are able to reap all of the rewards of restructuring, but, due to government prescribed demand (and now pricing with a sloped demand curve), none of the risk.
The IMM, in 2011, continues, "This [the impacts from a vertical demand curve] can hinder long-term contracting and investment by making it extremely difficult for potential investors to forecast the capacity market prices and revenues. In fact, it may be difficult for an investor to forecast that the market will be short in the future with enough certainty that its forecasted capacity revenues will be substantially greater than zero. This undermines the effectiveness of the capacity market in maintaining adequate resources."
We don't dispute there will be pricing volatility, and that such volatility does make it challenging for investors. But is the solution really to have the government put into place what are, essentially, price controls (or more aptly, price supports, since these controls will never serve to cap customer rates -- quite the opposite?)
Shouldn't we expect the market to find a solution to any challenges itself, through competition among bright and innovative individuals offering secondary or alternative markets or arbitrage-type products? Are we so quick to embrace the notion that private investors now can't deal with volatility, and need a government bailout in the form of a sloped demand curve to support desired prices? If so, why have any private investment in the electric industry at all? Shut it down, and municipalize everything.
The push for a downward sloping demand curve in MISO is just another example of how it's never enough for supposedly "competitive" generators, who really want the ability to earn unregulated profits without taking any risk, by having guaranteed cost recovery.
In ERCOT, the nodal market was supposed to be the promised land of efficient markets, but now having gotten that, generators are calling it inadequate, and asking for a centralized capacity market. And although some generators are at least forthright enough to advocate for a full-on PJM-style market, other proponents, knowing Texas' reluctance for such an administrative mechanism, have talked about more palatable designs -- a vertical demand curve, 1 year forward commitment instead of 3, no offer floors, etc. However, as sure as the sun rises in the east, we guarantee that if Texas adopted a "lite" capacity market, generators will be back in a year or two demanding "reforms" much like the MISO IMM's recommendations -- we've seen the same pleas from generators in MISO, ISO-NE, and NYISO, all capacity markets which either lack a sloping demand curve or a 3-year forward commitment (depending on market).
Even in PJM, the gold standard for an "efficient" capacity market in the eyes of asset owners, they want more. They want a longer forward commitment period to further assure future revenue streams, and changes to the demand curves or CONE to "reduce volatility"
Essentially, if these "reforms" continue, ratepayers are going to be back where they were before restructuring, at least in terms of guaranteeing costs for gold-plated assets. Except now, they will be denied at-cost power from the assets they've paid for, because all the revenue from ratepayers is extracted under the guise of "markets."
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July 12, 2013
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Copyright 2010-13 EnergyChoiceMatters.com
Reporting by Paul Ring • ring@energychoicematters.com
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