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

1995

20001994

20042003199219931990

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1998 1988

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1989 1991

0

10

20

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70

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

400

500

600

1-Jan

19-Jan

6-Feb

24-Feb

13-Mar

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Sp

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: