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Investors Say They're Willing to Take on Risk of Texas New Build -- Then Advocate Market Design Eliminating Any Substantive Risk

October 25, 2013

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Copyright 2010-13 EnergyChoiceMatters.com
Reporting by Paul Ring • ring@energychoicematters.com

Perry Capital, LLC and CarVal Investors, LLC filed comments with the Public Utility Commission of Texas yesterday stating that a, "properly designed forward capacity market is the most efficient mechanism to both achieve mandatory reserve margin requirements and satisfy [sought] fundamental principles."

In doing so, the investors claimed that, "Investors recognize that there are risks to investing in any market, including merchant energy, and do not seek guaranteed returns. However, an investor must have confidence that market rules will provide for the opportunity to realize the upside in the earnings of a business, in addition to bearing the losses the business may incur."

While investors claim to recognize, and therefore accept, risk in the merchant business, the advocated capacity market, along with the existing energy market design, essentially eliminates all substantive risk from investors, and all but guarantees returns for all assets but the marginal plant, particularly if the capacity market is "properly designed" in the eyes of investors.

Specifically, under the capacity market design, if a new investment clears, the new asset should be receiving, at a minimum, its Cost of New Entry, eliminating all substantive start-up and entry risk from the plant. If the investors are bidding rationally, they won't bid in their plant at a price lower than their CONE, so if the market doesn't reach that price, the unit simply doesn't clear, and the investors have no obligation to build.

To the extent the asset is deemed to have market power (unlikely for new investors), the capacity offer is still allowed to reflect going-forward costs, and units are able to request a unit-specific avoidable cost determination. Accordingly, even if the capacity offer is mitigated, if the offer clears, the going forward costs should be recovered, eliminating risk.

Matters realizes there will be some upfront and overhead costs needed to be incurred to prepare the asset to the point of being ready to be bid into the capacity auction, and therefore if the unit doesn't clear, these costs are lost. However, these costs are extremely small for any rational actor, who won't begin construction until the plant clears.

The risk of these minimal stranded costs is also greatly mitigated, however, by the potential to earn inframarginal revenues in the capacity market. Under the single clearing price methodology, all but the marginal unit won't just earn its going-forward fixed costs (the supposed "missing money"), but will also earn margin between their actual costs and the clearing price, with virtually no risk of unrecovered costs.

Then, as we proceed to the energy market, the single clearing price nature of that market also eliminates all variable cost risk from plants. Plants are only dispatched if their bids (presumably bid at marginal cost) clear, so if a plant clears, it should be recovering its variable costs. Again, Matters realizes there will need to be some upfront and overhead costs to maintain plant availability to be dispatched (that might not be reflected in fixed costs covered by the capacity market -- fuel supply agreements, for instance), but the "risks" for these costs are dwarfed by the major costs (fixed and variable) which are guaranteed to be recovered if the plant clears the capacity market and energy market. And, again, not only does the dispatched plant recover its variable energy cost in the energy market, it can reap unregulated profits from the energy market if it produces power below the clearing price -- without taking on substantive risk.

Aside from the limited overhead discussed above, we see only two real risks left to investors in a capacity and energy market, neither of which is substantive to any competently run business. The first risk is that the asset simply miscalculated its going forward fixed costs, and therefore, it cleared the capacity market below the price needed to recover such costs. Aside from being mitigated by competent management, this would also be mitigated by inframarginal revenues for all but the marginal unit. The second risk is that the asset is operated in a poor manner, which again, isn't so much a market "risk" as it is the result of bad management.

We are sympathetic to the risk the energy market poses to investors (a trade-off for the boundless profits available), and understand investors wishing to minimize such risk. However, it seems that with the desired capacity market design, investors want to eliminate nearly all downside risk, while maintaining the full upside of inframarginal revenues from both energy and capacity, with no collar on such profits. Buyers in any natural market would not agree to such a lopsided trade, which is why investors are seeking government action to compel customers to accept these inequitable terms.

Finally, in their comments, the investors state that, "It is important that the Commission send this signal while there remains time to resolve the resource adequacy issue through market-based mechanisms, the hallmark of the Texas competitive market."

A greater hallmark of the Texas market has been customer choice, not market "based" designs created by the government. As former PUCT Chair Pat Wood said this spring, when Gov. Bush was pushing for electric restructuring, his clarion was a, "reduced role of government," in addition to better prices, better customer service, and technological innovation (note the customer, not investor, focus as well). Re-inserting the government into a field it had left, in the name of reducing the risk assumed by investors in earning inframarginal profits, is simply inconsistent with the "hallmarks" of the Texas competitive market

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