Chasing the Uncatchable
This article was published in the May 2016 Fortnightly Magazine and co-authored by Delia Patterson of the American Public Power Association.
To ensure service reliability, companies responsible for supplying electricity to consumers - what the industry refers to as "load-serving entities" - are obligated by regulators to hold adequate levels of reserve generating capacity. Many of these companies look to auctions run by regional transmission organizations (RTOs) and independent system operators (ISOs) to meet some or all of their capacity obligations. While something of a misnomer, these capacity "markets" have been a fixture of RTO/ISO operations around the country for over a decade.
In three of these regions - PJM, ISO New England and New York ISO - participation by load-serving entities is mandatory. But it is impossible to say that these mandatory markets have made things better for suppliers, consumers or state regulators. On the contrary, existing generators continue to complain that they are undercompensated, state regulators worry that needed capacity is not being built, or at least is not being built where it is needed, and higher payments to generators have not improved reliability.
FERC's efforts to get capacity markets "right" in these regions have instead led to endless - and futile - tinkering. As the problems with mandatory capacity markets have popped up, FERC has been chasing them like the arcade player in a game of whack-a-mole: FERC hits the problem, seemingly head on, only to see the same problem, or a brand new one, pop up somewhere else. And the process starts all over again. Worse yet, as FERC has attempted to address each problem it has adopted a hodge-podge of fixes and exemptions - particularly related to its rules setting floors on seller bids - that become increasingly hard to reconcile with one another. It's time for FERC to start over, or at least to regroup and reassess.
Understanding FERC's view of the role of capacity markets begins with its conception of the principal benefit it expected to come from separating the generation of electricity from its delivery. "One of the benefits often ascribed to restructuring was that this risk would be allocated in a more efficient manner, specifically, on those most responsible for the risk and best able to bear it. That principle was expected to result in shifting more of the risk to investors, rewarding good decisions and penalizing bad ones, rather than the regulatory approach of giving all (or at least all minimally prudent) investments the same return."
Central to the success of wholesale competition in the RTO/ISO markets was the locational marginal pricing (LMP) of energy. This, FERC said, would "send price signals that are likely to encourage efficient location of new generating resources, dispatch of new and existing generating resources, and expansion of the transmission system."
But the use of LMP was not unqualified. To protect ratepayers in the restructured wholesale market environments FERC had encouraged from market power abuses, the newly-formed ISOs proposed caps on the prices of energy sold in their markets. These price caps, however, themselves soon prompted complaints from generators. With caps on energy prices mandated by ISO market rules, generators successfully argued, they would be undercompensated if they could not be paid for their capacity to make up the revenue shortfall created by these energy price caps. The first capacity markets proposed by the eastern ISOs were a direct response to the so-called "missing money" problem posed by these very caps. The cure proposed in PJM, ISO New England and the New York ISO, however, - making their capacity auction markets mandatory - has unfortunately proved far worse than the disease. Initially touted as "auxiliary markets" intended to supplement long term bilateral markets, the mandatory auction markets in ISO-NE, PJM and NYISO quickly morphed into the default mechanisms for capacity procurement.
And the problems appeared almost immediately.