The following is a contributed article by Elise Caplan, director of electric markets analysis at the American Public Power Association.
Over the past few years, the Federal Energy Regulatory Commission has approved fundamental changes to the rules governing energy markets and capacity constructs within several regional transmission organizations and independent system operators. These changes have been rooted in theories about how capacity and energy prices inform resource investment decisions – but data on recent investments in generating capacity show that these theories do not match reality.
The theory behind recent market rule changes
The most noteworthy and controversial of the recent RTO/ISO market rule changes has been the significant expansion of buyer-side mitigation within the capacity constructs of the Eastern RTOs (PJM Interconnection, ISO-New England and the New York ISO). The primary rationale offered by FERC and supporters of this expansion is the need to prevent capacity "price suppression," primarily as a result of state "subsidies" supporting procurement of resources to achieve clean energy policy goals.
Such price suppression, the argument goes, will interfere with the markets' ability to send the right "price signals" to guide investment and retirement decisions. For example, in its December 2019 order to expand the applicability of the minimum offer price rule in PJM's capacity construct, FERC opined that an administratively determined offer floor would "enable PJM's capacity market to send price signals on which investors and consumers can rely to guide the orderly entry and exit of economically efficient capacity resources."
This rationale is not limited to the capacity constructs. In the order approving PJM's recent changes to its reserve market rules, FERC stated that the current market is failing to "yield market prices that reasonably reflect the marginal cost of procuring necessary reserves, and to send appropriate price signals for efficient resource investment."
Such conclusions rest on the premise that prices in the RTO/ISO-operated markets are a key driver of investment decisions. FERC's decisions on market rule changes have focused on ensuring that merchant generation owners earn sufficient revenue, and as a result, created impediments to the development of resources by states, utilities and customers. This market design framework does not reflect how generating capacity investments are made in the real world and ignores the problems inherent in an excessive reliance on merchant generation.
Who funds capacity
The American Public Power Association conducts an annual assessment of the financial arrangements behind new electric generation capacity. Three main conclusions can be drawn from the most recent study, which covered resources that came online in 2018 and 2019: (1) while the share of total generating capacity that is financed entirely from market revenue has grown in recent years, the majority of new megawatts are constructed under longer-term, more stable financing arrangements such as bilateral contracts and ownership; (2) the recent growth in generating capacity financed entirely from market revenue is not a positive development and should not be the driver of market design; and (3) resource diversity, technology innovation and emissions reductions can be best achieved by projects developed to achieve utility, consumer and state policy goals.
Specifically, the findings of APPA's analysis include:
- 38% of the new capacity that began service in 2018 and 16% that began service in 2019 receive revenue solely from the wholesale markets (known as "merchant plants"). Such levels of merchant generation are relatively new – until 2015, this generation accounted for 5% or less of new capacity.
- Within the RTOs/ISOs, merchant capacity accounted for 49% of new capacity in 2018 and 24% in 2019.
- Merchant plants were composed almost entirely of natural gas-fired generation (92% in 2018 and 99% in 2019), despite concerns in several RTO/ISOs about relying too heavily on natural gas. For example, ISO-New England, which represented 30% of the new merchant natural gas generation last year, stated that the region has an "energy security problem" largely because it "relies most on gas delivered through its constrained pipeline system."
- Merchant generation was highly concentrated within PJM, which accounted for two-thirds of the new merchant generation in both years. Not all this generation was needed, either. PJM procured 9,500 MW of excess capacity in 2018 and 11,000 MW in 2019, according to Monitoring Analytics.
- Utility projects (bilateral contracts and ownership) accounted for approximately half of the new capacity in each year and were characterized by a greater diversity of resources than merchant generation. In 2018, about half of the utility-sponsored new capacity was natural gas, one-fourth was solar, and one-fifth was wind; and in 2019, those three technologies each accounted for about one-third of utility capacity additions. Small amounts of hydropower, geothermal, biomass or biogas, and fuel cells were among the utility projects, but not the merchant projects.
- Bilateral contracts for renewable resources and storage with large end-use customers accounted for 6% and 15% of the total new capacity in 2018 and 2019 respectively, compared to 12% and 11% in 2016 and 2017.
Markets should not be designed for merchants
These data show that FERC's efforts to root out so-called "price suppression" is unnecessary and ultimately detrimental to promoting a resource mix that meets reliability and policy objectives.
APPA's analysis demonstrates that resource diversity, technology innovation and emissions reductions can be best achieved by financial arrangements made by utilities and customers, rather than merchant developers. Many of those arrangements have been driven by state and local utility policy decisions to achieve specific policy goals. Market design decisions with a focus on achieving the "right" price signals are a detriment to non-merchant sources. And to date, merchant investments have led to excess procurement of a homogenous resource type. Moreover, such administrative scaffolding of prices creates a pool of merchant resources with a continued interest in propping up their earnings with further price supports.
Markets designed to support merchant generation in the name of "price signals" will lose the benefits of state, utility and customer-driven resource development. It is time that market rule decisions match the reality of how generation capacity is actually being developed.