Letting the market, not MOPR, decide in PJM's capacity mechanism
The following is a Viewpoint by Mike Hogan, senior advisor at the Regulatory Assistance Project.
As we await a FERC decision in the latest chapter of the PJM capacity market saga, Calpine and several other power developers in PJM recently made a passionate plea to FERC that only a blanket minimum offer price rule ("MOPR") applied to all state-incentivized resources is consistent with the "fundamental American belief" of letting the market decide.
Charging a fair price for competing products or services and letting customers decide what to buy is indeed the "American Way," although on closer inspection, that doesn't seem to be what Calpine and its brethren intend.
Let's look at what it would really mean.
The American Way
Let's start with the "capacity market," the market intervention that is the subject of the debate. Competitive power markets were established in order to meet consumers' demand for reliable electricity at the lowest reasonable cost. The idea is to set a fair price for electric energy — a price that reflects its true marginal cost — and let buyers decide how much to buy and when to buy it. In other words, the American Way.
Delivering reliable electric service at any given time requires not only resources producing energy but also resources providing a range of services to keep the grid running — frequency regulation, operating reserves, etc.— every hour of every day of the year. The true marginal cost of serving all of that demand can range from zero (or even less than zero) in some hours, to tens or maybe a few hundred dollars per megawatt-hour (MWh) in most hours, to thousands or even tens of thousands of dollars per MWh in critical peak hours.
In some markets — ERCOT, for example, or the Australian National Electricity Market — wholesale energy market prices are "fair" prices that are free to reflect that true marginal cost, with comparatively minimal intervention. In these markets, buyers can decide how much to buy when the price is $50 a MWh versus how much they want to buy when the price is $500 or $5,000 per MWh.
Buyers know that when reserve margins get thin, they'll see higher prices more frequently, and they can decide how and when to hedge that risk through forward contracts with suppliers. Indeed, most of the ERCOT market is hedged with forward contracts. That's how a market decides how much and what kinds of generation are needed to meet consumers' demand.
And as has increasingly been demonstrated, it works. ERCOT is meeting the same standard for reliability as PJM or ISO New England (ISO-NE), at lower average prices and with significantly lower reserve margins.
Of course, a certain amount of capacity margin is needed, but the market also allows that some consumers can and will choose to use electricity at another time of day rather than pay the high (but fair and economically appropriate) price for generation to produce it at the peak hour. The market also allows buyers to decide not only how much generation is enough, but what kind of resources can best meet their needs.
Denying customer choice
But it appears that Calpine and the other generators who signed the letter to FERC are happy with a mechanism — the "capacity market" — that denies consumers that choice. They don't really seem to want the market to decide. Instead, they want technocrats at system operators to make that decision for us.
So in regions like PJM, we have centrally planned purchases by system administrators of the amount of generating capacity they think we need three years in the future. And any old generating capacity will do, regardless of how well suited its operational attributes are to the changing shape of the market or consumers' preferences. It's paid for separately, out of sight, rather than through energy prices, thus denying buyers the information they need to determine whether or not the generation they're buying is worth the money.
The result might explain why Calpine prefers this arrangement to truly letting the market decide: reserve margins two to three times as high as in ERCOT, meeting the same reliability standard, at much higher prices.
Being enthusiastic supporters of taking this decision out of consumers' hands, Calpine et al. then go on to insist that "fundamental American belief" dictates we buy whatever capacity is able to offer the lowest price after applying their blanket MOPR, regardless of what kind of capacity it is. But is that based on fair energy market prices — on true marginal cost? It turns out, for now at least, that the answer is decidedly "No." It reflects energy prices that omit a significant cost — the externality cost associated with emitting greenhouse gases.
Most consumers now recognize that there's a real marginal cost to buying high-carbon energy instead of low-carbon energy. A recent U.S. government study attached a very large price tag to that recognition. But that cost isn't currently reflected in PJM energy prices because the federal government has so far failed in its duty to address that market externality through cap-and-trade, tax or other measures. As a result, some high-carbon generation can use that effective subsidy to offer a lower price in the capacity mechanism than some low-carbon alternatives. This forces consumers to pay for generation that they know carries higher marginal energy costs.
More and more consumers — whether they be businesses from across the spectrum, or citizens in cities or states acting through their local elected representatives — are deciding that until that market failure is addressed, they will choose to buy their electricity from a portfolio of resources they believe will deliver the low-cost mix of reliable electricity that fair pricing (that is, "the market") would produce. That includes contracting bilaterally, an essential market activity. That's what we usually refer to as demand.
Once again, what Calpine et al. are asking for suggests that they don't want consumers to have that choice. Instead, they want administrators to frustrate decisions by consumers and local communities in the PJM footprint to choose what they believe to be the best deal.
If, as a result of those choices, a wind farm or a nuclear plant is more competitive in capacity auctions than a coal plant or a gas plant, a MOPR such as what Calpine is asking for would amount to the system operators rigging the bids to negate the effect of local communities choosing what they believe to be the lowest-cost mix of electricity. They say they want the market to decide, but their proposal says otherwise.
By all means, let's let the market decide. Done correctly, that is the American Way. But let's recognize too that that's not what Calpine et al. are proposing. The "market" they are talking about is a central planning mechanism that has already taken one crucial market decision out of the market's hands.
There's an elegant way out of this if parties want to take it — phase out the capacity mechanism and put the money back where it belongs, in the energy market. Barring that, let's make sure, as buyers consider the market decisions still left to them, that the choices they're offered reflect fair prices — prices that reflect what consumers and local citizens have decided is the true marginal cost of energy from the capacity for which they're being forced to pay.