Capacity Markets for Texas Electricity: The Real Story

The issue of further refining Texas’ electric markets to ensure adequate investment to meet peak electric demand has continued to receive increasing attention since the blistering summer of 2011.  Justifiable concern exists among power companies, policy makers and companies regarding the reliability of the state’s electricity supply given the economic growth of the state.  At the same time, industrial, commercial and residential consumers want competitive electricity costs. Capacity markets would create a traded market for electrical “capacity”, not just for the “energy only” that a consumer purchases today.  This subject has generated a number of opinions on all sides of the issue, many of them incomplete at best or ill-informed at worst.

Proponents of forward capacity markets argue that generators will add capacity for the future if they will be compensated for that capacity and not just the electricity in order to provide a longer investment-planning horizon.  Opponents of capacity markets argue that there is nothing inherently different about electricity as a market that requires a capacity market.  They further posit that new generating capacity would be allocated and rewarded based upon planners’ projections rather than market mechanism, leading to a de-facto reregulation of markets and a tax on consumers and manufacturers.  In theory, all of these arguments could be true.  In practice, when implemented properly, markets are likely to look quite different than in theory and capacity markets could provide another free market mechanism to ensure Texas a low cost-reliable power supply.

First, lets look at the argument that there is nothing different about power as a commodity that requires you to create a capacity market – i.e. you buy milk, not cow capacity and power should be no different.  A better comparison is to look at other energy markets.  The natural gas market has a significant forward market with visibility into pricing a number of years out.  Natural gas storage plays a vital role in meeting peak winter and summer demand.  On the crude oil side, spare capacity in crude oil markets, especially OPEC capacity, is a closely watched barometer.  Crude oil also can be stored.   Power production markets contain none of these elements to balance short and long-term needs and nor provide reliable estimates of market-clearing prices four and five years out in Texas.

Second, some would argue it is a tax as consumers could be charged a fee to fund payments into a capacity market.  However, if designed properly, demand side management (DSM) providers would be allowed to participate in a capacity market.  DSM providers could come into the market and pay consumers to curb their demand at peak through controlling their power compensation, providing interruptible power etc.  In a capacity market, these providers would also have the effect of bidding down the price in capacity markets.  Results in the PJM (Pennsylvania, Ohio area) have conclusively shown that DSM will significantly reduce the price of capacity.  Prior to adoption of capacity markets, ERCOT and the PUC would have to work to ensure that sufficient DSM technology exists on the Texas grid to insure that the demand side the equation can be as responsive as the supply side in order to avoid this type of tax.

Third, the issue trying to be addressed is peak supply and peak demand.  Critics of capacity markets argue that existing generators receive 90% of payments into capacity markets.  The real question is not who receives the payments, but what generation assets are included in the capacity market design.  Several options are under consideration in the U.K. to address this question.   Under one proposal being examined by their national grid, only plants that do not otherwise participate in the wholesale energy markets would be eligible to be included – plants currently mothballed, decommissioned or constructed strictly for last-resort peaking purposes.  Also under consideration are lengthier capacity contract terms for new generation assets versus existing assets.  By providing more favorable terms to new generation assets versus existing assets, the market designers are attempting to add as little resource costs as possible.  Careful consideration and study will need to be done to insure that any of these types of mechanisms have over the long term their intended effect – providing a balanced playing field for all investors in the generation market and an equal risk/reward opportunity for a profit or loss.

Finally, let’s acknowledge that there are some unknowns around their success (as there are about the long-term success of deregulated markets in general.)  Australia has successfully operated a deregulated electricity market since the late 1990s without capacity markets and has been able to successfully incent adequate construction of generation capacity.  The U.K and France have not and are in the process of implementing limited capacity markets.  Statistics show that capacity markets have been relatively successful in the PJM market area of the U.S.  One clear message comes from the research – it will take time.  For a capacity market to work efficiently, it will take a period of four to five years for it to begin to function efficiently.  Thus, other short-term initiatives may be needed to address the state’s reserve margin issue.

Bottom line – the current market structure isn’t perfect as evidenced by its current state.  A capacity market if designed properly could be a step in the right direction.  Deregulated markets for power are a relatively new phenomenon –in existence globally for no more than 15 years.  Just as every other market evolves, Texas power markets will have to evolve to insure a safe, competitively priced electricity supply.