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FERC Chair: "Flawed" PJM Capacity Performance Design Will Allow Generator To Profit From Non-Performance

June 10, 2015

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Copyright 2010-15 EnergyChoiceMatters.com
Reporting by Paul Ring • ring@energychoicematters.com

In a dissent from a FERC order largely adopting PJM's capacity performance proposal without modification, FERC Chairman Norman Bay warned that the flawed market design adopted by his colleagues will allow generators to profit despite non-performance.

"[T]the proposal has a serious design flaw that undercuts the very aim that it seeks to achieve, which is to provide greater assurance of delivery of energy and reserves during emergencies ... [T]his flaw is an expensive one: the CPP may result in billions in additional costs for consumers without achieving its intended aim. PJM's capacity market is structurally non-competitive, and the CPP largely eliminates mitigation as a safety net up to .85 of Net Cost of New Entry (CONE). I recognize the difficulty of doing cost-benefit analysis and do not believe it is needed every time a market rule is changed. But, here, given the potential multi-billion dollar cost of the CPP and the burden consumers will be asked to bear, any analysis, no matter how rudimentary, would have been helpful before concluding this proposal is just and reasonable," Bay said

Bay explained that higher revenues from the capacity performance auction may offset any penalties a resource would incur for non-performance.

"Taken together, the CPP's incentive structure creates an opportunity for resources to profit from non-performance, as long as the first carrot – the auction clearing price, which can be up to .85 of Net CONE or more if the marginal generator can justify its unit specific costs – is larger than the partial stick, which, with 14 assumed performance assessment hours, would be .40 of Net CONE. A rational profit-maximizing resource could simply seek a capacity award in the auction, fail to perform during each performance assessment hour, and likely pay a penalty less than the carrot it has received. To put it more bluntly, the resource could be paid for doing nothing during the emergency hours of the year when it is most needed and for which it has been well compensated. And there is a built-in optionality period of three years, since the auction has a delivery year of 2018-19. During that three-year period, the resource may decide whether it wishes to meet its obligation when called upon, purchase replacement capacity to buy its way out of its obligation, or fail to respond. During the delivery year itself, the resource also has optionality because it can weigh the penalty of failing to perform during each Performance Assessment Hour, as a fraction of one-thirtieth of .85 of Net CONE. In short, PJM has purchased little certainty for what may be a lot of money," Bay said

"To be sure, the second carrot provides a financial incentive for resources to deliver during emergencies. But it is also true that the resource that fails to perform may be able to pocket the difference between the award it received and the penalty. As a matter of economic theory, to incent performance, a resource that never performs should pay a penalty at least as large as the amount it receives in compensation. Here, performance is not incented because the gain may be substantially greater than the penalty; the first carrot is larger than the partial stick. The second carrot provides even more compensation to incent performance but does nothing to remedy the initial disparity," Bay said

"The weakness inherent in the CPP's design creates significant incentives to move auction clearing prices up to .85 of Net CONE, because only prices above that level are subject to mitigation in the form of unit specific review. The temptation to exercise market power in the auction will be considerable. This would be less of a problem if one could count on the salutary benefits of competition. But, as PJM and the Market Monitor recognize, this market is structurally non-competitive. And the mitigation rules that are usually the safety net in such markets have largely been removed. Thus, the CPP creates the very real risk of the unmitigated exercise of market power up to .85 of Net CONE," Bay said

"The CPP's potential cost is also troubling relative to the benefit it may provide. In October 2014, PJM estimated that the net incremental cost for the CPP would be $1.4 to 4.0 billion. One way of viewing the CPP is that it fixes a several hundred million dollar uplift problem in the energy market with a multi-billion dollar redesign of the capacity market. Let me be clear: I support reliability. It is one of the most fundamental services a Regional Transmission Organization or Independent System Operator can provide. I also believe in the benefits of competition and markets. But the question here is not whether to support markets or reliability; rather, it is one of cost relative to the potential benefit and whether the CPP is a just and reasonable way to achieve a higher degree of performance in emergencies. Here, despite the potential multi-billion dollar burden consumers will be asked to bear, there is no analysis, however rudimentary, indicating whether the benefits are at least roughly commensurate with the costs," Bay said

"The majority today accepts a flawed, complex, highly technical market construct in which there is a potential mismatch between incentives and penalties, in which mitigation has largely been eliminated in a market characterized by structural non-competitiveness, and in which there may be billions in additional capacity market costs borne by consumers. The reality is that once a market construct is accepted and implemented, it is very difficult to unwind. Of all the costs associated with the CPP, not the least among them is this: the opportunity cost of the time and resources that could have been used to develop a more sustainable, efficient, and cost-effective design," Bay said

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