Want to Put an End to Capacity Markets? Think Real-Time Pricing
Introduction
In many wholesale electric markets, one finds both energy and capacity markets. The capacity market component was created to insure that a sufficient supply reserve margin would exist to assure the reliability of the electric system. In the event of a supply disruption, the reserve margin enables the electric system to manage the situation without the need to deny electricity to customers that want to buy it. In most other markets, supply disruptions are handled differently. Supply disruptions trigger price increases that, in turn, cause demand to drop down to the level of supply. When the price system is used in this way to ration demand, no one that wants to buy is turned away, although they have to pay a premium price.
The electric market has long presented a challenge to the use of price as a rationing tool. The lack of real-time demand response and other factors caused regulators to reject the use of price as a rationing tool in favor of a requirement that a supply reserve margin be maintained. This approach made sense, and continues to make sense, so long as the electric industry remains in its current state in which price signals to consumers – real-time price signals – fail to be employed in any significant way.1 With price rationing inoperable, substantial supply reserve margins must be maintained.
In this article, I will describe the decision made at the time of electric restructuring to continue to require reserve margins and how that decision, a reasonable one to make at the time, inexorably led to the need to have capacity markets. I will then describe how the need for capacity markets can be greatly reduced, or even eliminated, through the intensive use of real-time pricing.
Section snippets
The Crucial Role of Entry
Any discussion of wholesale electric issues must involve an understanding of the crucial role of entry – of new supply – in markets. Ultimately, it is the cost of entry that determines the price of a product. If the price in a market is too high, existing suppliers earn too much over the course of the year, other suppliers notice, and new suppliers enter. The added supply drives the market price down. This continues until the market price is driven down to the cost of entry, at which point the
Resource Adequacy at the Dawn of Electric Restructuring
In the mid-1990s, as regulators in parts of the United States were contemplating electric restructuring, one key policy question was what, if anything, to do to assure generation adequacy in a deregulated wholesale market.2
Why a Capacity Market Is Necessary, at Least for Now
The decision to maintain a 1-day-in-10 reliability standard is a government intervention into the deregulated electric market. It can be thought of as establishing a government-mandated level of scarcity rather than relying on a market determined one. This creates a problem, and this problem shows up in the wholesale energy market.
As with the hotel example, an electric energy market that contains too little scarcity to cover the cost of new entrants will rectify the situation via a lack of
Why Not Just Eliminate the Energy Market Bid Caps and Eliminate the Capacity Market?
Many observers have suggested that this whole problem can be solved simply by eliminating the bid caps on the energy market (currently set at $1,000/MWh in the East and $400/MWh in the West). This suggestion is inadvisable for two reasons.
First, eliminating the bid caps won’t raise enough additional money for generators. It simply won’t work. The problem for generators is not so much that the scarcity prices are too low; the bigger problem is that there are not enough of them. What the
Real-Time Pricing as the New “Peaker”
Peaking units, also known as combustion turbines, tend to run primarily during peak hours. At such times, the running cost of peakers generally set the market price. For peakers to recover their capital costs, they need to see prices that are above their running costs. The problem for peakers is that at peak times, the best they generally do is obtain a price set by other, somewhat less efficient peakers. The margin received at such times is meager. Very infrequently, the system is in shortage
Resource Adequacy Implications
As electric restructuring matures and more and more real-time pricing saturates the marketplace, revenues for generators will shift out of the capacity market and into the energy market. Eventually, perhaps, enough real-time pricing will be in place to allow the abandonment of the capacity market, and therefore, complete reliance on the energy market. From a generation investor's perspective, is this good or bad? I conclude that it is, on balance, good.
First, such an end-state represents a
Consumer Benefits
Consumers will be better off in an end-state that relies on real-time pricing and contains no capacity market. The simple reason for this is that there will be fewer generators to be paid.
From a generator's perspective, there is a tradeoff: revenues from the energy market will rise while payments via the capacity market will fall to zero. A peaking generator must have the increase in the former offset the decrease in the latter; after all, a market's average annual revenues, per supplier, must
The Transition for Capacity Markets: How Do We Get There?
The transition, in terms of the market design for the capacity market, is quite simple. Getting real-time pricing actually deployed in the retail electric market on a large scale is going to be the hard part, but, assuming that the real-time pricing job can be done, the changes needed to the capacity market design are straightforward and simple. This is certainly true if the capacity market design is the one used in New York, the so-called “Demand Curve” approach.
According to the demand curve
Conclusion
In conclusion, there are three main points that the reader should take away from this discussion. First, the cost of entry drives the long-run prices in the wholesale electricity market. The prices that generators receive cannot for too long be kept below or above the cost of a new generation entrant.
Second, in markets that operate under a government-mandated resource adequacy requirement, the amount of generation capacity that must be installed can, and often does, cause the energy market to
Mark Reeder is Director of the Office of Regulatory Economics, a group of 14 economists at the New York Department of Public Service in Albany. He has been an economist at the Department since 1979, testifying on issues of marginal cost, avoided cost, rate design, regulatory incentives, and policies concerning the wholesale electric market. Mr. Reeder, along with his colleague at the New York Department of Public Service, Dr. Thomas Paynter, developed the demand curve approach to the design of
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Demand response resources: Who is responsible for implementation in a deregulated market?
2010, EnergyCitation Excerpt :As a result, although TOU pricing can offer significant benefits, there is always the question as to whether this type of pricing is responsive enough for potentially rapid and sudden changes in system conditions. Expanding upon the benefits arguments for DRR, others have made the argument that a closer linkage between consumer demand and prices in the real-time market should do away with the requirement for capacity markets or regulations designed to ensure sufficient reserve margins [21]. The premise of this argument is that capacity markets and resource adequacy regulation institutionalize excess capacity required for reliability.
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Mark Reeder is Director of the Office of Regulatory Economics, a group of 14 economists at the New York Department of Public Service in Albany. He has been an economist at the Department since 1979, testifying on issues of marginal cost, avoided cost, rate design, regulatory incentives, and policies concerning the wholesale electric market. Mr. Reeder, along with his colleague at the New York Department of Public Service, Dr. Thomas Paynter, developed the demand curve approach to the design of capacity markets. He has a M.A. in Economics from Brown University and a B.S. in Economics from the University of Florida.
The views expressed in this article are solely those of the author and do not necessarily represent those of the Department of Public Service or the New York Public Service Commission. The author has benefited from comments by Rajendra Addepalli, Miles Bidwell, Alex Henney, Richard O’Neill, Thomas Paynter, and Steven Stoft, among others. The views expressed here are not necessarily attributable to any of these commenters, and any errors are solely the responsibility of the author. He can be contacted at [email protected].
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