NRG Integrated Model Shows How Mandatory Capacity Payments Would Force Retail Electric Providers to Subsidize Competitors

A discussion during yesterday's NRG Energy earnings conference call shows how Texas retail electric providers would be forced to subsidize their competitors if a mandatory capacity payment were introduced to the market.

An analyst asked NRG CEO David Crane how non-asset-owning REPs are hedging to address super-peaks this summer, and Crane responded that, "we wouldn't want to be going into this Texas summer without the wholesale to back up the retail."

Reliant President Jason Few added that, "absent having the ability to be backed up by the fully integrated model ... you're going to see more cost for the smaller retailers or non-integrated retailers, as those prices increase in the market ... we would expect to see pressure for them in terms of pricing, as well as their ability to have liquidity to support growth during the summer months."

The full exchange is below for context.

While Crane and Few were not discussing capacity obligations, they were showing the benefits the NRG retail businesses enjoy from being able to rely on affiliated generation. What makes this instructive with respect to a potential capacity obligation is who pays for these assets which are benefiting a single REP (or in this case, several REPs under a single parent).

Under current market rules, NRG must absorb costs to realize any benefits of its integrated model, namely, the fixed costs of the assets used to support retail. But depending on market conditions, those costs may go unrecovered.

Consider the 1,000 MW brought out of mothballed status by NRG. Analysts during the call noted that NRG incurred costs to return the units to service and will incur ongoing fixed costs to maintain their availability. This represents a risk if the summer is mild, and the market does not enter scarcity pricing (the benefits of the units mainly being either the load following capability under scarcity conditions to avoid NRG's retail load paying scarcity pricing and posting additional collateral, or alternatively, the units' earning scarcity revenues themselves)

Now consider if a capacity obligation were introduced into the ERCOT market. So long as the units cleared the capacity market or mechanism (and in the near term there would be no doubt they would given the lack of excess supply), the risk of maintaining these units' availability would be essentially nil. Fixed costs would be covered by capacity payments -- capacity payments funded by a tax on all retail electric providers in the market. However, the benefits of the unit would accrue to a single REP. NRG (or any other capacity owner clearing the market) would essentially have a free option to keep the units available to benefit their affiliated retail business, paid for by their competitors.

This subsidization raises questions that have not been acknowledged in any discussion of a capacity obligation in ERCOT. A mandatory capacity obligation on customers, through their REPs, is already inconsistent with PURA, but a capacity market design that forces REPs to subsidize their competitors would simply destroy the retail market, culling the number of REPs to the handful of REPs whose affiliate generation receives subsidy payments.

If regulators in the market are even entertaining the idea of some type of capacity obligation -- and there is talk there is at least conceptual discussions -- the ultimate market design must answer this fundamental question. PURA holds that a retail electric provider may not own generation, and regardless of what the original intent was, the operation of affiliated retail books and capacity makes the provision meaningless. However, if REPs were forced to buy a product from an affiliate of a competitor under a capacity market, a serious look at a potential prohibition on the same ultimate parent owning a REP and generator must be considered, or alternatively, a prohibition on a capacity asset affiliated with a REP from receiving capacity payments extracted from REPs.

It is not a suggestion Matters takes lightly, but if REPs are going to be mandated to purchase any product, they should have assurance that such product is not operated in a way that puts them out of business. Although capacity would be "competitively" provided by numerous sellers, it is essentially a monopoly service to the REP purchaser -- the REP must purchase capacity from the supplier as chosen by the capacity mechanism (even if a self-provided option were available, it is unworkable due to customer migration). In other instances where REPs are forced to procure a monopoly service -- such as transmission and distribution -- there are laws and regulations that provide such assets cannot be operated in a manner to favor an affiliate of the asset owner. While transmission and distribution are regulated services, the provision of capacity would essentially be a regulated service as well -- a REP would be obligated to pay for capacity the same way it is obligated to pay for transmission and distribution (that the price of capacity would be determined via competitive mechanism versus a rate case for T&D is irrelevant, the REP is still obligated to pay the rate determined by regulation, and has no choice but to take the service, or not serve customers).

Here is the complete exchange concerning the benefits of peaking assets discussed by NRG. Matters will also draw attention to a statement by Few concerning the palatability of a higher energy price cap to REPs:

Analyst:
And then just one other question on retail, can you talk a little bit about the competitive dynamics in that market. You mentioned that the competition on the C&I side was picking up. Is that for block products or for full requirements? And also for the guys that are marketing to the mass market, that don't have peaking generation to back up their load, how is it that they're hedging the super peak risk in the summer?

David Crane
Jason is obviously going to answer your question, but the second part of your question, I think is particularly interesting, because I can tell you we wouldn't want to be going into this Texas summer without the wholesale to back up the retail.

Jason Few
When you look at competition on the C&I side, we are seeing a change in the product mix. We're seeing more customers taking block and index-type products, which tend to, from a competitive standpoint, be more price competitive and at a lower margin. We're also seeing competitors in the marketplace driving price competition in the C&I space. So we're seeing both those things happen in the market and customers are willing to take more risk on their side of the ledger, as it relates to pricing given current power prices in the market. On the other part of your question with respect to how retailers are going after the mass market, absent having the ability to be backed up by the fully integrated model like we have with generation, clearly, I mean, you're seeing that their prices from a cost standpoint are going up because of what's happened with heat rate. And I think as they work with their sleeve providers, I think you're going to see more cost for the smaller retailers or non-integrated retailers, as those prices increase in the market, and I know at least from an advocacy standpoint, we're seeing a lot of, at least feedback from that group not wanting to see the price cap elevations that the PUC is talking about, which clearly states that there are some challenges for them in terms of managing that side of their business. And we would expect to see pressure for them in terms of pricing, as well as their ability to have liquidity to support growth during the summer months."

As can be seen, Few did not get into specifics regarding his statement about REPs "not wanting to see the price cap elevations that the PUC is talking about."

REPs have taken few public positions on the price cap issue; however, on information and belief from discussions with REPs, Matters believes the vast majority of any resistance is related solely to the August 1, 2012 date for the increase to $4,500, and what REPs considered a lack of adequate notice, and not opposition to a higher energy price cap in principle, though REPs' position on longer-term increases in the price cap are more diverse.

In 2006, in Project 31972, several retail suppliers had proposed a price cap of $6,000.