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NRG CEO Admits Merchant Build "Nearly Impossible" in Any Market, Including Capacity Markets, As Texas Chair Nelson Says Capacity Market Warrants Exploration

August 9, 2013

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Copyright 2010-13
Reporting by Paul Ring •

This story updated 3:30 pm ET 8/9 to reflect Crane's use of the term "nearly" impossible throughout. An earlier version has incorrectly used both the terms virtually and nearly in different places.

During an earnings call this morning, NRG CEO David Crane conceded that new build generation is not supported in any market, including eastern RTOs with capacity markets, on a merchant basis, and that "state sponsored" (ratepayer backed) contracts are needed for new build.

Crane's comments come on the same morning Donna Nelson, Chairman of the Public Utility Commission of Texas, filed a memo "strongly" urging the Commission to explore a capacity market further.

Specifically, Crane said that merchant new build is "nearly impossible", and that states are increasingly recognizing that a long-term off-take agreement is necessary to support new capacity investment.

"In the low gas price environment that exists, it's nearly impossible to justify the construction of new capacity on a merchant basis," Crane said.

"As the governors of various states consider how they are going to replace the wave of generation capacity that will be retired over the next few years as a result of either economic distress or environmental obsolescence, they are increasingly reaching the conclusion that they need to offer some sort of state-sponsored long-term off-take agreement, even for conventional new build," Crane said (emphasis added).

Although Crane did not specifically cite the capacity market RTOs as included in this position of not supporting new build, and needing a state-backed contract, it was clear from his comments he was including such markets with mandatory capacity payments (and he was clearly not speaking specifically to ERCOT)

Among other reasons, Crane cited NRG's brownfield sites -- largely in RTOs with capacity markets -- as well positioned to capitalize on regulators' understanding that long-term off-take agreements are needed to support new build generation. Additionally, his comment only makes sense if it were applicable to currently restructured markets (and all but Texas have a mandatory capacity obligation), as the non-restructured states rely on utilities, with ratepayer-backed construction, for new build. Notably, Crane said "governors" (plural), indicating he was not speaking solely about Texas. It's clear the Northeast states with capacity markets were included in his discussion.

Crane's comments come as Chairman Nelson filed a memo, in advance of today's PUCT open meeting, urging the Commission to continue to answer what she sees as fundamental questions regarding resource adequacy:

• Should the electric market in ERCOT continue to provide the same level of reliability to which Texans are accustomed, the same level that electric markets in the rest of the United States provide?

• If so, what is the planning reserve margin necessary to achieve that level of reliability and should it be a required planning reserve margin?

• What is the most efficient, market-based way of achieving the required planning reserve margin?

Nelson's complete 16-page memo can be found here

"Both the Brattle Group and the IMM have recommended a capacity market as the most efficient market mechanism to achieve a minimum planning reserve margin. We have not yet requested the filing of comments or held a workshop to explore whether ORDC B+ would be better from a cost/benefit standpoint than a capacity market. I know that many parties vigorously oppose a capacity market, but I believe we need to review the pros and cons of the various options before moving forward," Nelson said.

"Based upon the questions that linger in my mind regarding the solution that will best service Texans from both a reliability and cost perspective, I strongly believe we should explore this issue further, both in comments and in a workshop," Nelson said.

Nelson, citing the Brattle report, claimed that arguments that capacity markets have a higher cost than energy-only markets are a "myth," quoting Brattle as saying:

"It is not correct that capacity payments increase all-in customer costs. Capacity payments only replace the 'missing money' that results from high mandated reserve margins depressing energy market prices (by lowering market heat rates and avoiding scarcity prices). In capacity markets as well as energy-only markets, the all-in 'price' paid by customers must be sufficient to support investment in new generation."

However, capacity markets don't "only" replace the "missing money" as argued by Brattle (if they did, they would be closer to an efficient solution, but likely now opposed by incumbent asset owners seeking a windfall).

Instead, capacity markets pay all cleared resources the clearing price for capacity, whether that cleared capacity unit is already in-the-money, or is missing money, in the energy market. This is where the bulk of the excessive costs under a capacity market come from.

In-the-money resources get to double-dip. They receive the difference between their own going forward fixed costs and the capacity clearing price in the capacity market, PLUS their normal inframarginal revenues (already designed to allow them to recover fixed costs) in the energy market.

The inframarginal revenues which already exist in the energy market to support the fixed costs of capacity aren't eliminated, that's why capacity markets cost more. Although there are energy and ancillary service offsets meant to act as a pseudo-clawback to recognize this fundamental flaw of the capacity market, practice has shown that the offsets are inefficient, and notably do not evaluate actual margin made by plants, but rather those made by a fictitious reference unit.

Aside from the offset, the capacity market proponents claim that energy pricing volatility will decrease, thereby eliminating the existing inframarginal revenues and avoid over-compensation to capacity. Again, however, practice does not support this argument. Most scarcity pricing in ERCOT is driven by transient events, not resource inadequacy, so meeting a minimum reserve margin is not expected to appreciably decrease scarcity pricing. Nor does Brattle support a reduction in the ERCOT price caps if a capacity market were implemented, so the opportunity to earn inframarginal revenues (especially under the small-fish-swim-free rule, regardless of actual scarcity) would persist

Brattle is somewhat correct that pricing in any market, "must be sufficient to support investment in new generation," (we'll quibble with the term "generation" here in a podcast next week), but the capacity market goes beyond providing "sufficient" support for the reasons noted above, as well as several others.

Aside from the double-dip in inframarginal revenues, capacity markets produce excessive costs due to the normal operation of the sloped demand curve which, by its very design, can over-procure capacity (assuming Texas adopted a sloped demand curve as favored by asset owners).

Additionally, the capacity market can over-procure resources, and generate highly excessive costs, if the actual load in the delivery year is significantly under the forecast used to set the mandated capacity purchases -- thereby producing an actual reserve margin nearly double the mandated target. This forecasting error and risk of over-procurement is inherent in the central planning of the capacity market, and is akin to the potential wrong decisions made by regulators under the old integrated resource planning model used prior to restructuring -- risks from which customers were supposed to be freed.

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