The Convergence of Market Designs for Adequate Generating Capacity
Peter Cramton and Steven Stoft
24 March 2006
Converging positive ideas– High spot energy prices send efficient signals
– Long-term contracts fight market power
– Options reduce risk
– ICAP solves the reliability problem
– Demand elasticity is wonderful
Exaggerations & ideas attacking good ideas1. ICAP is anti-market (energy only)
2. Selling options restores the missing money
– Requiring long-term contracts is too centralized
– High prices mean too much risk / market power
– Options are too complex
– It’s all too complex! Wait for demand elasticity
Fallacy #1: Energy-only avoids administrative intervention
• Only in markets with responsive demand
• Current markets cannot price reliability
The principal reason for an energy-only market would be prices determined without either administrative price caps or other interventions.
– MISO, 2005
Quantity (MW)
$20,000
$10,000
Interventions
3%
7%
Requirement
Proposed modifications of the market’s energy demand curve for an energy-only market.
Energy +Reserves
$30
Price
Energy-Only Market “without Administrative Interventions”
MarketDemand curve
Market-driven scarcity (elasticity) revenues
Price
Quantity
Baseload MC
Peaker MC
Market scarcity revenues are infrequent and brief.
Need $80,000/MWh × 50,000MW
Price-cap Prices
(Admin)
No scarcity
rent
To test if market works with energy-only:
• Calculate expected rents from high spot prices• when installed capacity is adequate
Show:
market elasticity revenues > missing money ( ~ $ 4 billion)
What about a market for reliability?(instead of Energy-Only)
• It would black out low-value demanders first
• Right now we can’t do this
• Later, with fancy circuit breakers, we could
How are we doing?
1. Standard energy-only very administrative
2. Elastic energy-only not here yet
3. Energy-only + reliability market not here
But there is another way to attack ICAP:
Energy-Only isGood Administrative
ICAP is Bad Administrative
Comparing administrative transitions
• Energy-Only– Build the market of the future now– Wait for reality to catch up (real-time meters, etc.)– Easy for the regulator
• ICAP + High Energy Prices + Options– Stabilize the investment climate now– Protect consumers during the transition– Regulator must adjust market parameters– Easy on market participants
Combined approachderived from energy-only
High energy prices ($10,000)
+ Long-term contracts
+ Done as options
+ Make them mandatory
(backed by a penalty)
New energy-only and ICAP approaches:• Control reliability administratively• Use high spot prices for incentives• Differences depend on implementation details
AlmostICAP
Administrative Details
• Must load hedge the full adequate level of capacity?
• Does capacity have to sell load a hedge in order to get the high prices?
• Yes complete convergence• No
– Unclear investment signals– Market power not well controlled
1987
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20042003199219931990
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1989 1991
0
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90% 95% 100% 105% 110% 115%
Ratio of Installed Capacity to Target Capacity
Scarcity Hoursin Year
Best-Fit Trend
Suppliers did not like look ofEnergy-Only in ISO-NE after 18 years
Fallacy #2Call option restores missing money
0
100
200
300
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600
1-Jan
19-Jan
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31-Mar
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ot
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erg
y P
rice
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MW
h)
Cost of call option at $250 strike
California Average Energy Price in 2000
Call option does not restore missing money
• Competitive price just reflects cost• Generators give away their scarcity rents• Raising the price cap means they must give
back more scarcity rents• More risk less investment
Purpose of market
• Induce just enough investment to maintain adequate resources
• Induce efficient mix and operation of resources• Reduce market risk• Avoid market power in capacity market• Reduce market power in energy market
“If all else fails,then do the right thing.”
-- Evan Kwerel, FCC
• 1998: Traditional spot capacity market• 2004: Modern spot capacity market
– Addresses market power– Addresses performance incentives
• 2006: Forward capacity market– Addresses market power– Addresses performance incentives– Determines price from the cost of new entry
Round 3Forward Capacity Market
• Why forward capacity market?• Auction mechanics• Market power• Performance incentives
Why forward procurement?
• New projects compete in advance of entry– Coordinated entry– New capacity sets price directly
• Long-term commitment for new capacity– Reduced investor risk– Better price signal for new investment
Addressing market power
• Is essential• Strong incentive to exercise market power
– Existing capacity has substantial sunk costs– New capacity is only a tiny fraction of total– Market is concentrated, especially in zones
• Any of top-4 suppliers could unilaterally set price
• Long-term price signals are more stable and efficient if determined from competitive forces, rather than market power
Addressing market power
• New capacity– New capacity bids are not mitigated– Assumes competition for new capacity
• Delist bids from existing capacity– High bids submitted in advance and posted– High bids cannot set price– Only low bids can set price
Performance incentives
• Comes from scarcity prices in energy market• High scarcity prices are hedged
– Load is fully hedged by option for 100% of load– Suppliers are hedged by physical capacity
• Incentive is based on covering your share of load– Generators providing extra are paid extra– Generators providing less are paid less
Summary of Convergence
• Full strength scarcity pricing
• Mandatory load hedges with options
• Reliability controlled by capacity market
• Long-term contracts
• More demand response
– Capacity payments will melt away
Virtuous Dynamics
Missing money restored
Energy price increases
Price capraised
Mandatory hedges
Demand response increases
Un-hedged scarcity
revenue up
ICAP payments
down
Introduced with Forward Capacity Market:
Over time:
