Energy Legal Blog

PJM Ventures Thoughtfully into Vexatious World of Capacity Markets

The role of an electricity capacity market has been described as inducing the right amount of investment of the right type in the right locations.  (Cramton/Stoft 2005).  Following the contentious introduction (or proposed introduction) of capacity markets in New York and New England, the PJM Interconnection unveiled in a September 1 submission to FERC its reliability pricing model (RPM) for getting a capacity market “just right” in the Mid-Atlantic.  PJM’s filing with FERC came not quite a month after Congress instructed FERC to proceed cautiously with ISO New England’s comparable proposal for a locational installed capacity (LICAP) market.  For its part, PJM asked FERC to approve RPM no later than January 31 so that the Interconnection will be able to prepare for the first of what will become annual capacity auctions on June 1, 2006.  FERC is expected to convene soon a series of technical conferences on the RPM proposal.

The need for capacity markets for electricity are generally attributed to regulation that prevents consumers from seeing and responding to high prices during periods of scarcity — the absence of price-elastic demand — and the long-lead times typically required to increase supply either through new generating capacity or upgraded transmission.  As a result demand is not accurately or timely valued.  Like other operators of bulk power systems that must balance supply and load, PJM historically addressed this failing of existing electricity markets by hosting a capacity market as far as 12 months into the future and requiring all member load servers to maintain capacity equal to peak load plus a “reserve margin,” such as 15 percent.  Failure to maintain the reserve margin triggers a deficiency charge based on the cost of a new combustion turbine.  While this approach was copasetic in the traditional world of vertically integrated electric utilities, it deters sufficient investment in generation capacity in markets (such as much of PJM) in which generation is competitive and decoupled from transmission and load-serving distribution activities. 

This is because the fixed reserve margin and deficiency charge price capacity below the margin at zero and price capacity above the margin up to the deficiency charge — in other words, produce a demand curve that is vertical rather than the downward sloping curve that describes demand for most commodities.  The resulting prices will not recover the cost of a generator during extended periods until a shortage develops, causing prices to skyrocket, inducing over-investment in new capacity, and causing boom-bust cycles that have characterized large segments of the power industry in recent years.  While customers may like this result so long as they benefit from low prices during periods of sufficient capacity and are shielded by regulation from very high, scarcity prices, developers in competitive supply markets will not volunteer to invest in such markets. 

The reserve margin with deficiency charge approach was jettisoned first in New York, when NYISO replaced it with capacity prices set on a downward sloping demand curve that varies depending on the locational value of energy.  FERC authorized implementation of this pricing and a US appeals court upheld FERC against complaints from some consumer groups that the new pricing mechanism was a form of incentive pricing that required greater justification than FERC provided.  ISO-NE followed suit, but ran head long into withering opposition to its LICAP proposal, particularly from politicians and consumers in areas of New England that are notoriously short of capacity, such as Connecticut.  That opposition culminated with the US Congress including in the Domenici-Barton Energy Policy Act of 2005 in a “sense of Congress” admonishing FERC to evaluate carefully the objections to LICAP.  That admonition and FERC’s response derailed LICAP and capacity market reforms generally for at least one year in New England.

PJM’s contribution, RPM, is a more comprehensive and arguably more thoughtful approach to capacity market reform than that of either NYISO or ISO-NE.  Under RPM, PJM will conduct annual auctions for delivery of capacity to specified locations in each of the four seasons four years later (the Delivery Year).  The auction will not be confined to offers of generation.  Transmission owners/operators can also offer capacity, and consumers can offer capacity from reduced demand.  Each load server will be required to secure capacity sufficient for its peak load plus reserve margin in the Delivery Year through self-supplied capacity, bilaterally purchased capacity, or capacity committed in the auction for that year.  In lieu of the current deficiency charge, RPM contemplates a downward sloping demand curve called a variable resource requirement (VRR) curve.  While PJM presents several options for the VRR curve (in comparison to the implicit vertical curve of the existing deficiency charge), the slope of each curve is set in relation to the annual fixed cost of a combustion turbine.  Payments to sellers whose capacity clears in the auctions would equal the annual cost fixed cost of a combustion turbine, less revenues to such a turbine from forecasted energy and ancillary services sales.

To placate American Electric Power (a relatively new member of PJM), PJM included in  “draft business rules” accompanying its FERC filing AEP’s proposal that would allow a load-serving member to opt out of RPM under certain circumstances.  In order to do so the load server would have to demonstrate that it possessed sufficient capacity to meet it peak load plus reserve margin four years in advance.  PJM does not indicate support or opposition to this opt out, presenting it to FERC as a jump ball.

PJM makes a strong case that its RPM is an improvement over the status quo.  By looking four-years into the future, RPM stands to provide a predictable and stable cash flow to generators and investors.  Locational pricing will help ensure actual deliverability of capacity into constrained areas, which has often been lacking in the past.  At the same time, revenues from the VRR curve, together with seasonal differentiation that permits imports of capacity that could not otherwise commit on an annual or semi-annual basis, should ensure capacity adequacy at minimum long-term prices.  Notwithstanding these attributes of RPM, representatives of large industrial users and representatives of rate payers in capacity-short locations understand the price tag for adequate capacity and have vowed to fight it.