Part 1: Capacity Market – Lipstick on a Pig
“The desire for safety stands against every great and noble enterprise” Tacitus
Please ponder the above quote from a Roman philosopher. This quote applies to many things beyond this discussion of capacity markets in the power sector.
PJM is making a drastic change in its capacity model. This is a two part article with the first part covering the creation of the capacity market. I believe if you understand how you got to where you are now, you will be better equipped to reflect on the future. Part 2 will go over the issues in the new PJM proposed capacity market.
History of Capacity Markets
Unfortunately, an analysis on the capacity markets cannot be examined without a discussion of regulation vs. de-regulation. To many, this is akin to discussing politics, race, and/or religion. I will attempt to stick with the facts and avoid absolutes.
In a regulated world, there is no need for a capacity market as investments are made once the utility shows to the utility commission the investment is prudent to meet a certain loss of load probability requirement. In a perfect world, the commission, interveners (industrial lobbyist, consumer protections groups), and the utility produce some reasonable acceptance to the need of generation capacity and then, and only then, does generation get built. In return for this consensus opinion, the utility is protected from a loss if the generation is not needed in the future. At the same time, the utility is capped in its earning potential.
However, this regulated system does come with some cost as previously discussed in my Regulation vs. De-Regulation article. A regulated system does not bode well for adoption of new methods and technology. The system is focused on maintaining. Overtime cost can rise without proper oversight from the commission. As I noted in a previous article, this is likely inevitable given the poor levels of compensation in the commission. In my latest research, the Ohio public utility commission earns between $75-$160K per governor approval. This is a full time job as commissioners are not only regulating electric utilities but also natural gas, telephone, water, railroad, and motor carriers.
Within the electric sector, they are dealing with the executives making multi-million dollar salaries each year. Then the senior management team earns around $500K with directors making $130-300K. You have analysts coming out of college in the utility, potentially, making more than the commissioners and their staff. With this design, it is no wonder the effectiveness of regulation would wane. It is certainly reasonable to expect commissioners and staff to have the potential desire to work at the utility in order to support their families. This very fact could make it hard for some to really clamp down on their potential employer. Please note none of my statements are absolutes nor are they confirmed in anyway with current commissioners or staff. I use my practical insights on human behavior to potentially deduce these outcomes along with past history. There has been confirmed revolving door in the electric utility space as in the Duke Energy Corp case where the chief legal counsel for the states utility regulatory agency joined Duke Energy Corp after presiding on two cases favorable to Duke. I strongly suspect, if he ruled unfavorably in the cases, he might not have had the job.
The history of poor regulatory decisions led many to investigate the de-regulation option vs. fixing the regulatory process through increase budget to source and retain skilled and experience commission and staff. Ideally, competition will drive the inefficiencies out of the market that the regulatory body could not. Theoretically it made sense given poor decisions were not being punitive as in a free market and the drive for innovation was not there as there was no earnings potential beyond a set return. Both of these points still could have been somewhat managed by the regulatory agencies. Another bonus of de-regulation many touted was allowing greater transparency and market discovery which would potentially allow new companies to innovate and capture the market thereby reducing society cost. De-regulation would drive the inefficiencies out of the market and the innovative nature of competition will drive the cost down further. It all sounds so good on paper.
Markets became de-regulated with California leading the way. We all know what happened there. The first market inefficiency they attacked wasn’t the inefficient operation of the utility but the inefficiencies of the market model – Enron Strategy. To me, this highlights that the inefficiency of the utility really isn’t that large compared to the inefficient market designs. If you think this was resolved due to the experience in California – think again. In 2010 JP Morgan hired John Howard Bartholomew. He wasn’t hired to progress the electric industry nor drive out inefficiencies in the utility but to find the inefficiencies in the market design. Once again they quickly identified inefficiencies and targeted those arbitrages to the benefit of themselves. A regulated entity would have not done that given the lack of incentive. However, these free market players realize there is more money in market manipulation than the boring optimization of power plant supply chain. In addition, the risk from getting “caught” still produces a decent return on investment after accounting for the penalties.
As an outcome, many deregulated markets kept a price cap to “protect” the consumer. PJM price cap is at $1000/MWh. ERCOT is having to raise their price cap as they stayed on the moral high ground on de-regulation and continued without a capacity market. The one thing ERCOT is doing is raising the market price cap from $2,500/MWH (2011) to $9,000/MWH (2015) in order to incentivize generation build. To prevent a market brownout or blackout, demand must be met even in the one instantaneous moment of ultra-high demand. Typically, power planners will build peakers to run for those given moments. However, in a free market system, they need to have enough revenue during those small times to make up for the cost of building the unit. Therefore, if your peaker cost you 85 million dollars for 85 MW and you only ran 40 hours in the year in order to have a payback in 3 years without any discounting you would need prices to average over $8300/MWh PLUS variable cost during those 40 hours. Variable cost can be over $100+/MWh given rise in fuel prices in extreme times. ERCOT is running the grand experiment to drive new technology and new methods through price incentives – the quintessential mechanism of a free market. It is just math. A market with regulation typically gets a return on investment between 8-12%. If the market is free to compete, the risk is increased. Therefore, the reward needs to increase above the regulated return requirements. The returns will likely need to grow to over 15+% rate of return. The means to this return, I contend, is too great for society. I do agree the potential for a more efficient market is very possible with an open market, but society and potentially the oversight body is not willing to take the means needed to achieve the ends of a more efficient market.
Other Regional Transmission Organizations (RTO) realized the incentive to build generation with power prices alone did not meet their historical comforts of market reserve margins and consumer pricing. They became concerned about the customer backlash to the de-regulated market, if they could not deliver the same comforts of a regulated market. The capacity market was born to hide this issue while still touting the free market solution as the answer to society’s needs. PJM came out with Reliability Pricing Model (RPM). RPM creates another layer of payment beyond the price of power. In theory, it is the value of having capacity available to serve load. Payment is based on the size of your capacity offer. The initial model was opened to all sorts of capacity options from coal plants to non-generating capacity from demand response aggregators. This model still offered some innovation by just targeting the peak demand and not putting so many strings to the participation in the auction. At this point I still believed there was a possibility to obtain the promise savings of de-regulation.
However, the latest proposal to modify RPM by PJM goes against the “free” de-regulated concepts of free market competition. The proposed RPM is likely losing all the value of being de-regulated compared to regulation. Stay tune for your early Sunday release as we detail the latest PJM PRM proposal in Part 2 Capacity Market – Lipstick on a Pig.
Your Willing to Step Out of the Box Energy Analyst,
David
David K. Bellman
All Energy Consulting LLC- “Independent analysis and opinions without a bias.”
614-356-0484
[email protected]
@AECDKB
blog: http://allenergyconsulting.com/blog/category/market-insights/
