Proceedings of the 51st Hawaii International Conference on System Sciences | 2018

The Use of Marginal Energy Costs in the Design of U.S. Capacity Markets Robert Moye Sean Meyn∗

Abstract tions were expected to spur innovation and reduce costs to consumers. And like the experience with This paper surveys the development of marginal AT&T, opinions on the results of the deregulation cost theories used in the optimal allocation of scarce of the electric power industry are mixed. resources, and examines the application of these Wholesale power markets in the U.S. today rep- theories to current-day electricity capacity markets. resent a patchwork of policies and approaches that The different approaches in use today to ensure grid impact, if not outright dictate, how capacity, energy reliability and incentivize new resources are exam- and related products are bought and sold. While ined. Market challenges are surveyed, as well as some aspects of all markets appear to function well, empirical findings that suggest that current market there continues to be much debate about the efficacy approaches do not provide proper incentives. We of some. This is particularly true for the markets de- conclude that the so-called “missing money” is not signed to ensure that sufficient electric generation is missing because of defects in market designs, or so- in place today and being planned and constructed called administrative actions—money to incentivize for future use. These Capacity Markets currently investments is missing due to a misapplication of take many and varied forms across the U.S. Most marginal cost theory. markets, but not all, define a minimum resource Acknowledgements Research supported by the Na- requirement that entities directly serving customer tional Science Foundation under grants CPS-0931416 load are required to meet. Some rely on bilateral and EPCN-1609131. We thank Professors David Spence, markets to meet these requirements. Others have Amy Stein, and Seth Blumsack for their insightful com- ments and encouragement. Their input as well as sug- very structured processes (e.g., auctions) to facili- gestions from the reviewers were carefully considered in tate the purchase and sale of generating capacity. the revised manuscript. And while there are many prominent individuals in- volved in the market-structure debate today who be- 1 Introduction lieve long-term markets will self-optimize if only we Much of the social history of the West- can be patient, this issue is far from settled. ern world over the past three decades has There is little scientific basis to predict that long- involved replacing what worked with what term optimality will emerge from short-term deci- sounded good. – Thomas Sowell sion making by generation operators. One challenge Driven by claims during the last quarter of the 20th to analysis is that there is no agreement on how to century of anticompetitive behavior by electric utili- quantify risk to society or to an individual agent in ties, frustrations by consumers having to bear much the market. Another challenge is the enormous un- of the risk of large electric generation investments, certainty over planning horizons of many decades. and a desire by many to create a more economi- The risk to a generator operator is obvious in to- cally efficient market for the electric power industry, day’s technological environment: the lifetime of an the United States began to deregulate (or “reregu- efficient combined-cycle generating station may be a late”) certain aspects of the electric power industry. half century, and its purchase price over one billion Starting with the Public Utilities Regulatory Poli- dollars. At the same time, revenue over this period cies Act (“PURPA”) in 1978 and continuing with depends on uncertain energy prices and policy. energy policy acts in 1992 and 2005, the U.S. whole- The remainder of this paper is organized as fol- sale power markets (and in some states, the retail lows: The evolution of regulation of the electric markets) were opened to more competition. Much power industry is discussed in Section2 to provide like the deregulation of AT&T in the 1980s, these ac- a backdrop for the state of the markets today. Sec- tion3 contains a short history of marginal cost the- ∗The authors are with the Department of Electrical and ory and its use in today’s energy and capacity mar- Computer Engineering at the University of Florida. RM is kets. This theory is based on the notion of efficiency, a doctoral candidate at UF and executive at Rainbow En- ergy [email protected]. SM is the Robert C. Pittman Eminent whose definition is based on a hypothetical Social Scholar Chair at UF [email protected]. Planner’s Problem.

URI: http://hdl.handle.net/10125/50214 Page 2575 ISBN: 978-0-9981331-1-9 1 (CC BY-NC-ND 4.0) Current market structures are surveyed in Sec- lowing development of rules by the Federal Energy tion4, with emphasis on the elements of mecha- Regulatory Commission (FERC), the high-voltage nisms used to incentivize investment in generating transmission systems that interconnect the utilities resources. It is here where we find potential gaps in the United States began providing open access to between the hoped-for optimal Social Planner’s so- all existing utilities and wholesale generators, and lution, and the outcomes of markets in a real-world non-utilities were allowed to own and operate elec- setting. Some of these shortcomings are discussed tric generation for sale into the wholesale market. In in Section5, and potential solutions are presented addition, entities called power marketers (at the be- in Section6. ginning of the electricity markets, typically affiliates 2 Evolution of the Power Industry of utilities and investment banks) could participate freely in the market by purchasing electricity from Today, electricity is so basic to the world economy one entity and selling to another. that certain electricity indices are used to express a The re-regulation of the electric power industry country’s economic standing (consumption or pro- led to regional organizations designated to operate duction of electricity per capita) and the standard the high-voltage transmission systems on a state- of living enjoyed by consumers (per capita electricity wide or multi-state basis, and to implement electric- consumption in the domestic sector [16]. As such, ity markets for the purchase and sale of electricity the availability and cost of electricity is fundamen- products. Underlying each of the markets is a par- tal to the economic wellbeing and prosperity of a ticular mathematical formulation of efficiency, and society. surrounding marginal cost analysis is the core of Primarily as a result of competitive market forces, this philosophy. The following section examines the the electric power industry has evolved significantly foundation for these markets and the problems they over time. Generating resources have become more create (see Section 4 for a discussion of these new reliable and efficient. High-voltage transmission net- markets). works, nonexistent at the birth of the industry, are now extremely reliable and efficient. 3 Marginal Cost and Efficiency Practices and procedures, both for system opera- [E]very tub must stand on its own bottom, tion and for long-term planning, have also improved and that therefore the products of every in- greatly and now contribute to the overall value and dustry must be sold at prices so high as to efficiency of the industry. While many improve- cover not only marginal costs but also all ments were realized in the early days through trial the fixed costs, including interest on irrevo- and error, today’s systems benefit from the extensive cable and often hypothetical investments... use of computers to optimize both short-term opera- Hotelling [19, pg. 242]. tion and longer-term system expansion. These tools Short- and long-term optimization of resources in have been particularly helpful in enhancing short- today’s Organized Markets lean heavily on marginal and long-term planning techniques and practices. cost theory and the concepts of economic efficiency. The regulatory paradigm has also changed sig- A major weakness is their reliance on short-run nificantly over the history of the electric power marginal costs to provide long-run investment sig- industry—starting first with regulation by munic- nals. A review of the research regarding the use ipalities through the granting of franchises. This of marginal costs to set the price for factors of pro- was followed by the creation of public service com- duction reveals that some other means of addressing missions in each state, and eventually regulation of the fixed cost of assets is needed; this fact was recog- wholesale market activities at the federal level. In nized by commonly cited authors in this field, such general, these changes were made to protect electric- as Coase and Schweppe. ity consumers from anti-competitive behavior [16]. 3.1 Marginal Costs In the second half of the 20th century, the indus- The discussion of the use of marginal cost pric- try was again changed to promote more competi- ing for public utility projects began with a French tion. The Public Utilities Regulatory Policy Act of engineer in the 1800s. Jules Dupuit introduced the 1978 for the first time allowed companies other than concept of marginal utility in an 1844 article con- regulated utilities to sell electricity in the wholesale cerned with the optimum toll for a bridge [12]. This power market (limited to renewable energy and co- theory was further formalized by Alfred Marshall in generation resources). 1890 when he combined the ideas of supply and de- The passage of the Energy Policy Act of 1992 mand, marginal utility and costs of production [25]. marked a significant evolution of the industry. Fol- In 1937, Harold Hotelling presented an update to

Page 2576 2 the work of Dupuit (and used the supply and de- co-authors [4,5, 36], led up to the book that many mand curves of Marshall) to argue, among other today point to as the basis for the use of marginal things, that the use of tolls on bridges in New Jersey cost pricing in Organized Markets - Spot Pricing of was resulting in less-than-optimal use [19]. Hotelling Electricity [34]. argued that because the amount of the toll was It is a crucial fact that all of the prior research and above the marginal cost to allow people to use the analysis into the use of marginal costs from Dupuit bridge (which was essentially $0), it prevented some to Schweppe, et al, are consistent with the idea that from utilizing the bridge that would otherwise ben- while prices for electricity at marginal cost optimize efit from such use (because their marginal value was the general welfare in the short-run, basing revenues above $0, but less than the amount of the toll). entirely on short-run marginal costs is not sufficient In 1946, R. H. Coase addressed the issues pre- to recover fixed costs, and therefore insufficient to sented by Hotelling and others and specifically incentivize investment in generation. focused on the “conditions of decreasing costs” 3.2 Social Planner’s Problem on Engineering [19, 20]; see also [24, 27]. Coase agreed that the Timescales amount paid for goods and services should equal the Economic systems are said to be Pareto optimal marginal cost to produce or provide the goods and if there is no alternative way to “organize the pro- services. However, he pointed out that whenever duction and distribution of goods that makes some marginal costs are less than average costs, the to- consumer better off without making some other con- tal amount paid for a product will fall short of total sumer worse off” [26]. costs. The is particularly relevant to the optimiza- From a power supply perspective, a power system tion of power systems, where average total costs are is said to be operating under optimal conditions if well above average marginal costs. there is no alternative way to lower short-run2 costs Marginal analysis was first applied to investments by redispatching or modifying the commitment of in electric power supply by the Electricit´ede France available generating resources. However, over the (EDF) in the late 1940s and in the 1950s. While long-run a system can be said to be optimal only if most efforts in the United States were focused on investment decisions are also incorporated into the the theoretical aspects of marginal pricing, EDF analysis. That is, a long-term power supply plan can was concerned more with the practical implemen- be said to realize Pareto optimality only if there is tation [30, 38]. This work led EDF to implement no other combination of existing and potential re- a transmission tariff in 1957 that utilized marginal sources, along with the optimal commitment and cost pricing and incorporated these same concepts dispatch once given these resources, over the useful into long-term investments. Marcel Boiteux (during life of the resources. How can an approach that only this time an engineer at EDF and later its Chair- uses short-run marginal costs, and ignores long-term man), studied the relation between short- and long- investment costs, provide for an optimum system? run marginal cost pricing. The solution provided by Boiteux, et al, was to increase the price beyond The primary challenge with incentivizing invest- marginal costs. EDF continues to lead in both the ments in today’s electricity markets centers around economics and the engineering foundations for long- the time frame covered by our decisions. Operating term planning and investment [1]. Quantifying risk decisions are short term; from a few minutes to a aversion and uncertainty is an essential component few years. Investment decisions are long term; from of this research. a few years to several decades. More specifically: In the 1970s, work in this area continued by • Decisions on the optimal use of generating re- Baumol and Bradford [3] and Feldstein [13], where sources to serve the expected load 5 minutes Ramsey-Boiteux pricing1 was used to derive how in the future consider only those resources cur- prices should be increased above marginal cost in or- rently on line and synchronized to the system. der to meet “social revenue requirements.” In 1971, • Decisions on the optimal use of generating re- Vickrey introduced the concepts of “real-time pric- sources to serve the expected load 30 minutes ing” for a product, albeit for telephone service pric- in the future consider those resources currently ing [3]. However, it wasn’t until the 1980s when work on line and synchronized to the system, plus by Schweppe, et al, focused specifically on electric- those that can be brought on line and ramped ity [6]. This work, along with other work done by his up to provide the desired output within that

1Ramsey-Boiteux pricing is a policy concerning what price 2“Short-run” in this context refers to the period from the a monopolist should set, to maximize social welfare, subject next five minutes through the next few years (i.e., as limited to a constraint on profit. by the time it takes to install additional generating resources).

Page 2577 3 time frame. term “customer” is reserved for the end-consumer • Decisions on the optimal use of generating re- of electricity—residential, commercial or industrial. sources to serve the expected load 3 days in the 4.1 Marginal Pricing in RTOs future consider almost all existing and available Both Independent System Operators (ISOs) and resources. Regional Transmission Organizations (RTOs) are • Decisions on the optimal use of generating re- organizations formed with the approval of the FERC sources to serve the expected load 10 years in to coordinate, control and monitor the use of the the future consider all existing resources, plus electric transmission system by utilities, generators any resources and technologies that can be in- and marketers. More specifically, an ISO, as spec- stalled prior to this time. Also, resource over- ified in FERC Order 888, is a non-profit organiza- hauls, repowerings and retirements are consid- tion that is designed to provide non-discriminatory ered over these longer time scales. service to all market participants, and is indepen- While there is theory to support the emergence dent of the transmission owners and the customers of efficiency as the result of short-term optimization who use its system. RTOs, defined in FERC Or- by selfish agents in the market, this theory is not der 2000,4 also provide non-discriminatory access to likely to be predictive on the timescales of interest in the transmission network, but have some additional this paper. We believe that a long-term invest- responsibilities dealing with transmission planning ment scenario that is consistent with Pareto and expansion for the entire region served by the optimality can be achieved only with a certain RTO. level of long-term planning. Today there are nine ISOs/RTOs operating in 4 Organized Markets in the U.S. North America. They manage the systems that The electricity markets in the U.S. today can be serve two thirds of the customers in the U.S., and viewed as falling into one of two paradigms. There over half the population of Canada. Over time, the continue to be “bilateral markets” in which buyers distinction between ISOs and RTOs in the United and sellers negotiate the purchase and sale of en- States has become insignificant. Both organizations ergy and capacity directly with each other.3 These provide similar transmission services under a single transactions can range in timescale from the next tariff at a single rate, and they operate energy mar- hour up to several decades, and the characteristics kets within their footprints. For brevity, we refer (e.g., firmness, delivery location and price) can be to either ISOs or RTOs, or collectively Organized different for every transaction. And while under cur- Markets, simply as “RTOs.” rent regulations, any entity can participate in these The Locational Marginal Price (LMP) is intended transactions, it takes a certain set of knowledge and to be the cost of supplying, at least-cost, the next skills to be effective in this market. increment of electric demand at a specific location Outside of the bilateral markets, and covering (node) on the electric power network, taking into most of the U.S., Organized Markets have been es- account both supply (generation/import) offers and tablished to provide for the buying and selling of demand (load/export) bids and the physical aspects energy, ancillary services and, in some cases capac- of the transmission system, including transmission ity, via a central clearing mechanism. The primary and other operational constraints [37]. By design, purpose of these markets is to separate generation when the lowest-priced electricity can be delivered to and retail electric service from the natural monopoly all locations in the market footprint (i.e., there are functions of transmission and distribution. no transmission constraints), and ignoring electrical The primary agents in these models are gen- losses, prices are the same across the entire RTO. eration companies that supply the electric power, However, when power flowing over the transmission and the Load-Serving Entities (LSEs) that are system reaches limits designed to ensure reliable op- responsible for providing electric service to re- eration, the lowest-priced energy cannot flow freely tail customers [14]. Examples include investor- to some locations and more expensive generation is owned electric utilities such as Pacific Gas & Elec- required to serve the load in the constrained regions. tric, and not-for-profit community-choice aggrega- Under this scenario, LMPs are subsequently higher tors (CCAs) such as Marin Clean Energy. The in those locations. A key element of the structure of energy markets 3Bilateral markets for all capacity and energy products continue to operate in the southeast and parts of the western 4While the functions of RTOs are similar to those of ISOs, U.S. Most of the country continues to utilize bilateral markets FERC chose to use a new name in Order 2000 for its desired for capacity—at least for meeting part of the markets’ needs. form of transmission organizations in the U.S.

Page 2578 4 within all RTOs is that resource owners and LSEs lieved to provide inadequate incentives for investors submit offers to sell and bids to buy hourly blocks in new generating capacity (or equivalent demand- of energy for all 24 hours of the next operating day. side resources) to invest in sufficient new capacity to The RTO takes these offers and bids and determines match administrative reliability criteria [22] because the least cost, security constrained commitment and of these market failures. “The fundamental source dispatch of resources to serve the LSEs for the next of the net revenue gap problem is the failure of spot operating day. Out of this process, day-ahead LMPs energy and operating reserve markets to perform in are created from the prices offered and bid by the practice the way they are supposed to perform in participants. theory [21].” The consequence is that prices paid to In addition to this day-ahead market is a real- generators in the energy and ancillary service mar- time market in which LMPs are calculated every kets are substantially below the levels required to five minutes and represent the price that LSEs will stimulate new entry. pay and generators will be paid for the subsequent Organized Markets have therefore been useful in five-minute period. Even when subject to transmis- bringing efficiencies to short-term system operations sion limitations or ramping constraints on genera- and dispatch, but, in the opinion of some [9], have tion, prices in excess of marginal cost, and even neg- been a failure in what was advertised as a principal ative prices are consistent with economic efficiency benefit: stimulating suitable new investment where [11, 39]. it is needed, and when it is needed. 4.2 “Administrative Actions” 4.3 Scarcity Pricing Many entities involved in the RTOs (RTO staff, Scarcity occurs when available generation is in- market participants, market monitors, regulators, sufficient to cover the expected energy and operat- and market advisors) believe that an economically ing reserves required for reliable operation. Scarcity efficient market is one in which the only compensa- Pricing provides for an increase in the LMP during tion paid to a generator is tied to a markets’ short- defined scarcity conditions—such conditions being term LMP [8, 18]. Whether or not this is true, they tied to the level of reserves (regulating, spinning, universally recognize that problems with the mar- standby, etc.) available to be called upon if needed. kets’ design keep the markets from operating effi- As touted by the supporters of this approach, this ciently. They believe these problems include: is a means to stimulate a more competitive market 1. A lack of direct participation by the customers and to better provide incentives for investments in within the same timescales as the generators supply-side and demand-side resources. (e.g., hourly). 10,000 2. The use of price caps to limit the maximum Value of Lost Load (VOLL)

price an LMP can rise to, and thus limit the 8,000 potential revenue a generator can receive. 3. The use of “administrative actions ” by system 6,000 VOLL x LOLP operators to ensure reliable system operations. 4,000 Minimum While by design, LMPs are not subject to Reserves 2,000 manipulation by market participants, in prac- ($/MWh) Scarcity Price

tice system operators have substantial discre- 0 0 0.5 1 1.5 2 2.5 tion over LMP results through the ability to Reserves (GW) classify units as running in “out-of-merit dis- patch.”5 When this occurs, these units are ex- Figure 1: Operating Reserve Demand Curve cluded from the LMP calculation which often Some RTOs have implemented versions of Scarcity results in depressing market prices.6 Pricing with the design of pricing mechanisms based The missing money problem often cited in capac- on two concepts from traditional system planning: 1. ity market research refers to a class of failures in the Value of Lost Load (VOLL), in units of $/MWh, organized markets. That is, expected net revenues that is intended to represent the cost to the ultimate from sales of energy and ancillary services are be- electricity consumers when load is interrupted, and 5This indicates that one or more resources being dis- 2. Loss of Load Probability (LOLP), defined as the patched are done so for reasons other than economics. probability that the entire load cannot be served. 6 Under these circumstances, more expensive generation is As an example of one Scarcity Pricing design, brought on line but not allowed to set the market LMP. Other generators are then required to reduce output, further lower- ERCOT utilizes an Operating Reserve Demand ing the overall market LMP. Curve (ORDC) which adds a Scarcity Price to the

Page 2579 5 LMP during any defined periods of scarcity. Figure the country [15].7 And while FPL still operates un- 1 illustrates the basic structure of the ORDC used der a cost-of-service, rate-of-return paradigm, even in the ERCOT market [18]. with this significant expansion of its generation base, The primary components of an ORDC include: i) it has seen very little increase in retail rates over this a price, assumed equal to the VOLL, to be paid to all same period. resources participating in the real-time market when 5 Critique of Methods used to Incen- operating reserves fall below a set level (assumed tivize Resource Investments equal to the market’s minimum operating reserve The fundamental assumption behind today’s level); and ii) a price to be paid to all resources RTOs is that if competitive market forces are al- participating in the real-time market as operating lowed to take place in the daily and hourly energy reserves approach the minimum designated level. and ancillary services markets, the resulting prices Though the ERCOT report is not clear, it is as- (LMPs) will provide all of the incentives needed sumed that the market operator would determine a for supply side resources. That is, these markets real-time LOLP that corresponds to the settlement alone can optimize the Social Welfare. The theory period in question. The VOLL is assumed to be supporting this assumption is flawed, and moreover applicable to all customer classes, and independent there is no empirical evidence that short-term mar- of time. Research has indicated a significant range kets will lead to long-term optimality. for VOLL in practice, with values depending on the 5.1 Critique of Energy-Only Market Designs time of day, day of week, customer class and also on duration [23, 33]. Consequently, the real-time LOLP For the energy-only market theory to work, funda- and stationary VOLL are parameters that the mar- mental changes need to occur in the market design. kets are currently not equipped to precisely define 1. Eliminate Reserve Margin Criteria – In or calculate. [11, 39] it is shown that a competitive equilib- rium will result in optimized reserves from the 4.4 Incentivizing Investments perspective of the social planner, and average The methods used in the RTOs in the United prices will equal average marginal costs. This States to incentivize investment in new generation conclusion is valid even with the introduction fall into three categories: of ramping constraints, and uncertain demand and supply. However, hiding behind these • Energy-only: An approach wherein revenues mathematical conclusions is this fact: there will from the energy markets (and ancillary services be no long-term equilibrium since the genera- markets) are expected to provide sufficient com- tion companies will not be able to cover their pensation and price signals to optimize resource fixed costs. investments. It has been argued that the reserve margin cri- • Energy + Capacity Markets: The above teria in place in the markets, wherein defined energy-only pricing approach, plus formal ca- levels of generating capacity in excess of what pacity markets, which together are expected to is necessary to serve the forecasted peak load, provide sufficient compensation and price sig- must be relaxed, if not eliminated. Without this nals to optimize resource investments. change, the markets will rarely be without suf- • Traditional: Least-cost, long-term resource ficient installed capacity to serve peak loads.8 planning methods that have been used by util- 2. Provide for Direct Retail Participation – ities for decades as “incentives” for investment Retail consumers of electricity must be given decisions. For utilities whose generation invest- the ability, and have the desire, to participate ments are still regulated by state utility com- directly in the market. It is claimed that they missions, this approach involves demonstrating must in fact respond in real-time to market that a proposed expansion plan is “best” (e.g., price signals (see Borenstein’s survey [7] and least cost, or close thereto) of the plans evalu- Wolak’s testimony to the California state gov- ated. ernment [41]). While significant technological Outside of the RTOs, the Traditional method is being employed, and with good success. Over the 7Since 2002, FPL has added over 15,000 MW of highly past 15 years, for example, the largest investor- efficient, natural gas-fired generation. 8 owned utility in the state of Florida (Florida Power Current reserve margin requirements in place across most of the U.S. (12% to 20% of projected annual peak load) en- & Light, or FPL) has invested in some of the most ef- sures that generation is available to serve load 99.97% of the ficient and cost-effective combined-cycle facilities in time.

Page 2580 6 advances have been made (e.g., with smart me- This is an odd construct given that in most mar- ters), it is still difficult to see how price signals kets resources are expected, if not required, to can be of value to customers, or of value to the submit offers into the day-ahead market. grid operator [28, 29]; in particular, price sig- 3. By design, Scarcity Pricing is tied to one price nals cannot produce high quality balancing re- (or percent of one price) that is assumed to rep- serves or ramping services that can be obtained resent the value to consumers for reliable ser- through distributed control [10]. vice. The use of one value for the VOLL, re- 3. Eliminate Administrative Actions – Ad- gardless of the time of day, time of year, class ministrative actions (market price caps and of customer, and duration of outage is incon- reliability-based, out-of-merit dispatches of re- sistent with a reasonable understanding of this sources) would have to be eliminated. parameter [23]. In the unlikely event that any of these changes 4. Up until recently, LOLP has been used as an could be made, we would still be challenged by other annual, long-term planning metric. The appli- issues. Even if regulators go along with the plan, will cation in ERCOT and other markets to oper- customers accept the reliability construct required ating time scales and conditions is misguided. to create the price spikes needed to incentivize gen- Therefore, unless the markets develop a mecha- eration? Will the trigger prices set by retail cus- nism to determine an LOLP-type metric given tomers for limiting service, equal or exceed those the exact operating conditions in place during required by resources to be adequately incentivized? the scarcity conditions, there is no foundation Will demand-side solutions crush any price spikes for its use in today’s markets. expected as a result of lower reliability standards? 5. Finally, the reliance on the energy markets to Like the Scarcity Pricing construct, without provide investment signals is inconsistent with crisis there will be no opportunity! the fundamental marginal cost theory as de- Because an energy-only structure would likely veloped by Dupuit, Hotelling, Coase, et al. operate in a manner similar to that of today’s Marginal costs cannot be used to incentivize in- Scarcity Pricing approaches, it is worthwhile to vestments when such costs are lower than aver- point out some significant short-comings in that age costs. pricing scheme. 5.2 Critique of Capacity Markets 1. Scarcity pricing in ERCOT and other markets is The Capacity Markets in use in PJM, ISO-NE, linked directly to conditions related to a lack of NYISO and, to a limited degree in MISO, also suffer operating reserves9 and not planning reserves.10 from poor design concepts. These include: Therefore, scarcity conditions occur when gen- • Short-term market horizon Thirty- to fifty- eration or transmission resources become un- year investments cannot be optimized in a mar- available or limited during the operating condi- ket that only provides for one- to seven-year tions. This rarely relates to the total capacity contracts.11 The consequence is that potential of resources installed in the market. investors demand higher returns on equity due 2. In the current market approach, Scarcity Pric- to the uncertain long-term economics of the ar- ing is only applied to generation and loads that rangements (that is, they shift the cost of these deviate from the amount cleared in the day- risks to the consumers), and they will natu- ahead market. Therefore, any resources that rally be biased toward resources that have lower submit offers in the day-ahead energy market, capital costs and higher variable costs (favoring clear this market, exactly generate the amount peaking resources over base load resources) [31, during the scarcity event that they cleared in Pg. 73]. that market, and which have no surplus capac- • Transmission Investment Coordination ity beyond what cleared, have no ability to re- Current market designs provide no explicit co- ceive the Scarcity Price for energy. They there- optimization with potential transmission im- fore receive none of these incentive revenues. provements, nor much, if any, implicit co-

9Operating reserves represent resource capability above 11“For the prospective investor in an expensive, forty-year firm system demand required to provide for regulation, load asset, it is next to impossible to estimate the probability that forecasting error, equipment forced and scheduled outages the competitively priced energy produced by the asset will and local area protection. produce a sufficient return over its lifetime (compared to ex- 10Planning reserves represent installed capacity above the isting or yet-to-be-invented alternatives), or whether the asset forecasted peak-hour firm system demand for a defined period will be rendered obsolete or uncompetitive by new regulation in the future. [35].”

Page 2581 7 optimization. Investors look only to existing (defined as serving their load, plus a level of and potential transmission topologies to decide reserves prescribed of the RTO) by any means on resource locations and have little to no con- they deem acceptable, as long as the capacity trol or influence over what the transmission acquired meets criteria established by the RTO. owners may or may not do in the future. • Long-Term Capacity Markets – Require • Natural Gas Infrastructure Coordination each LSE to have a portion of their capacity Like with transmission, the lack of coordination requirements (perhaps the majority of their re- with natural gas investments can significantly quirements) secured for a longer-term period hamper the market from realizing the ultimate (e.g., 20+ years instead of 1 year).14 “More economically efficient solution. forward contracting would be a good thing from • Reliance on Historical Energy Prices to both a market power mitigation perspective and set Capacity Price Caps – The demand from the perspective of those who believe that curves developed by each Capacity Market are price volatility, price uncertainty, and oppor- based on the Cost of New Entry12 for that mar- tunism are deterrents to investment [21].” ket, and nets out the expected value of en- • RTO as the System Planner – Have the ergy revenues that such a hypothetical resource RTO plan for the entire market footprint, com- would realize in the market. However, these petitively bid for generation to meet require- estimates are based on historical prices (PJM, ments, and allocate costs to market partici- for example, uses an average of the past three pants. years). Because the demand curve covers a pe- While we believe the above approaches are all su- riod three years in the future (for PJM), this perior to those currently adopted in the capacity means there is a six-year difference. Such a dif- markets in the U.S. today,15 it is the last approach ference could mean that future energy market that RTOs should implement. Under this best-of- prices could be significantly higher or lower than both-worlds approach, the most valuable features those assumed for the demand curve. of the traditional expansion planning approach16 The historical methods used to plan for and op- would be retained, while competition for the devel- timize resource expansion are not without faults. opment, ownership and operation of the resources Projects were sometimes planned and built to serve as seen in today’s RTO Capacity Markets would be load that never materialized. Some projects expe- preserved. rienced significant cost overruns, with these costs Similar to approaches utilized in CAISO and in typically passed on to consumers under the cost-of- the “non-organized” markets in the Western and 13 service, rate-of-return paradigm. Some of these Southeastern U.S., this approach would involve a cost overruns were due to changes in regulations dur- process where the following are determined through ing the development and construction of projects, a market-wide planning process that is conducted but some were due to poor management, or worse. by the RTO itself: 6 Resource Investment Solutions • Reliability requirements are established and We believe the solution to the problems identified tracked with today’s Capacity Markets lie in one or more • Future load requirements are forecasted hybrid approaches that borrow from the methods • Planned generation and transmission assets are perfected over time by traditional resource planners identified and incorporated and those methods that utilize competitive markets. • Long-term analyses are performed by the RTO These solutions are consistent with the expansion that identify: i) the amount of capacity needed, methods applied to industries with similar average- ii) the desired location of the capacity consid- to-marginal cost structures like the airline industry, ering existing and potential transmission and the automobile industry, and the hotel industry. natural gas (or other fuel supply) infrastruc- Three specific options are summarized below that ture, and iii) the desired technology of resources implement this proposed construct. used to provide the capacity (supply or demand • Laissez Faire – Allow LSEs to secure sufficient capacity to meet their capacity requirements 14Forward, multi-year contracting has long been recognized as a means to mitigate problems experienced in the short-term 12The Cost of New Entry, or CONE, is an estimate of the energy markets [2, 40]. cost to build the least-cost resource in each market. 15SPP is excluded, because it is essentially the Laissez Faire 13In August 2017, utilities in South Carolina announced approach and not a “formal” capacity market per se. the abandonment of the construction of two new units at the 16The planning methods and “best practices” used and per- Summer Nuclear Station.[32] fected by utilities over the past century.

Page 2582 8 side), with proper assessment of risks associated to provide adequate investment signals to existing with newer technologies. and potential resource owners [31]. This includes • Following development and agreement on a plan the lack of a contract term consistent with the en- for the market, competitive auctions will be gineering time-scales associated with generation in- held for suppliers to build the desired resources, vestments. They also ignore most, if not all, of the who would bear construction and performance strategic aspects concomitant with long-term plan- risks. ning (impacts on transmission, fuel supply infras- • The RTO will contract with the successful bid- tructure, fuel diversity, etc.). The solutions provided ders for the purchase of capacity and associated address these shortcomings. energy under long-term (e.g., 20-year+) agree- As described by Hayek [17] “planning” is the ments. “complex of interrelated decisions about the allo- • LSEs will be allocated17 the cost of capacity cation of our available resources.” In this context, required to reliably serve the market based on Hayek believed all economic activity can therefore their load-ratio share. be viewed as planning. And “in any society in A competitive process would then follow that which many people collaborate, this planning, who- would determine who would provide the desired re- ever does it, will in some measure have to be based sources and what the final prices for these resources on knowledge which, in the first instance, is not would be. given to the planner but to somebody else, which As suggested by [35], the reason the proposed ap- somehow will have to be conveyed to the planner.” proaches are superior lie in the foundational ques- The key issue is therefore not that planning is tions of energy policy. “How will society manage done, but who is to do the planning. So the key risk and uncertainty in energy markets?” “How will dispute regards whether planning is to be done cen- it manage the distribution of external costs and ben- trally, by one authority for the whole power supply efits not captured by market prices?” The proposed system, or is divided among many individuals. approaches will do this. Challenges in the creation of capacity markets has With the RTO as the overall System Planner, it been the focus of this paper. While short-term en- can incorporate all the “good” from traditional plan- ergy and ancillary markets are not perfect, the out- ning experience and take advantage of economies of come is largely as intended: the RTOs took well- scale to develop market-wide: (i) load and fuel price developed engineering methods and approaches used forecasts, (ii) technology assessments, (iii) transmis- by electric utilities to optimize power supply sys- sion and fuel supply infrastructure studies, and (iv) tems in the short-term, and simply applied them to assessments of political, legal and regulatory frame- larger systems. They have also taken advantage of works within which that markets may operate in the improvements in enhanced computing power to si- future. And like the energy markets, these can all be multaneously optimize energy, reserves and trans- done using best-in-class systems, models and meth- mission over these larger systems—something not ods. possible until relatively recently. Critics of the traditional approach to expansion However, unlike the energy and ancillary ser- of power systems should also be satisfied. While vices markets, the RTOs ignored most of the long- such plans will be developed by the RTO, construc- developed engineering methods and approaches to tion and performance risks will be borne by the in- optimizing power system expansion plans that cov- dependent developers and owners of the resources. ered longer time periods. This error adversely im- Cost overruns and performance penalties will there- pacts the investment incentives for all market par- fore not be directly passed through to eventual cus- ticipants. In essence, and again unlike the energy tomers. markets, the RTOs did not take a well-functioning 7 Conclusions system and make it better—they made it worse. Because, by design, the Capacity Market solutions References used by four of the RTO markets in the U.S. fail to [1] R. A¨ıd,S. Federico, H. Pham, and B. Villeneuve. incorporate many of the engineering principles used Explicit investment rules with time-to-build and un- in long-term resource acquisition, they are unable certainty. Journal of Economic Dynamics & Con- trol, 51:240–256, 2014. [2] B. Allaz and J. Vila. Cournot competition, forward 17One method is to charge each LSE an amount based on their “load ratio share” of the market’s total capacity require- markets and efficiency. Journal of Economic The- ment. This is similar to how capacity costs are allocated to ory, 59(1):1–16, 1993. LSEs in some RTOs today. [3] W. J. Baumol and D. F. Bradford. Optimal depar-

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