Energy Regulators Face Market Challenge

 | Sep 17, 2013 | 11:00 AM EDT
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The Federal Energy Regulatory Commission (FERC) has a problem. Their market-based solution to compensate deregulated power generators for capital investment appears to be flawed.

As a result, a growing number of utility executives representing Exelon (EXC), Entergy (ETR), FirstEnergy (FE), American Electric Power (AEP) and others are warning the markets are broken. As a result, FERC and state regulators must address the issue, or the nation will soon see reliability and price issues.

Capacity markets are designed to compensate utilities for capital investment. Currently, each FERC-approved Regional Transmission Organization (RTO) uses different rules. Some offer nothing. Others, like PJM Interconnection offer an auction for one year's worth of capacity, three years in advance. Nobody offers price discovery beyond five years.

Five years is nothing in utility space. Large-scale power plants take years to plan, design, engineer, permit, construct and prepare for operations. A project lifecycle frequently takes five or more years to complete. In addition, most baseload plants cost well over a billion dollars. To be competitive, these assets need to operate profitably for 25-to-40 years. Before any money is spent on a 25-year project, investors need to know if they will ever get their money back.

Under FERC-approved market rules, nobody can provide investors with an answer. Some can guess. Others can analyze. When it comes to plunking down a couple of billion dollars, however, guesses will not cut it. Consequently, capital is fleeing FERC-approved RTO markets and seeking safer returns.

The problem is not limited to new construction. Generating utilities that seek revenues from FERC-approved markets have no framework to plan preventive maintenance, upgrades or improvements. Consequently, generators are limiting capital improvements.

While one of FERC's missions is to assure reliability, they do not seem to be connecting the dots between infrastructure investments and reliability. Apparently, FERC has few concerns about providing price discovery for capacity. They do have concerns about reliability in capacity-constrained markets.

It gets worse. FERC-approved capacity market designs draw no distinction between asset classes. Capacity auctions generally assume generating assets are fungible. While some RTOs discount wind and solar, capacity markets generally value nuclear, coal, gas turbine, hydroelectric and energy efficiency equally. If the market signals a need for new capacity, the highest return will always be for the generator offering the lowest capital expenditure, not levelized cost.

For those not familiar with power markets, the equivalent to FERC's approach would be for the Commodity Futures Trading Commission to approve only one market and one price for silver, gold and platinum. As metal prices increase, investors would naturally shun platinum and gold. Instead, they would always buy the cheapest commodity to get the highest price.

The same is true for the capacity markets. Instead of silver, gold and platinum, the power markets offer peaking, intermediate and baseload plants. Peakers have low capital expenditures and high production costs. Baseloads have high capital expenditures and low production costs. Intermediate are in between. Under FERC's approach, no utility is motivated to invest in platinum or baseload generators.

As evidence, no utility relying on FERC's RTOs for their revenue has invested in a new baseload power plant. The only new baseload plants built in the US are found in regulated markets where the government guarantees utilities' shareholders they will earn a fair return on their assets.

Examples of new base loaded plants are Southern's (SO) new nuclear plants at Vogtle and their new coal plant at Kemper County. Another is SCANA's (SCG) new nuclear units at V.C. Summer. All of them have government-guaranteed return on assets (e.g., capacity payments).

There is a solution. First, FERC could separate the metals and create separate capacity markets. One market could be limited to baseload generators, which must be able to produce power 24 hours a day, rain or shine. Another market could be limited to peaking production, which must be dispatchable anytime within a 24-hour period. The third market could be for non-dispatchable generators, such as wind and solar.

Second, FERC could treat capacity like all other commodities. FERC could require RTOs to offer market prices for years in advance and updated continuously. This would provide investors price discovery and liquidity.

Third, FERC could create a single rule. This rule would be consistent for all the nation's power markets. While each market may produce different prices, the process creating those prices would be the same.If FERC does nothing, reliability may deteriorate and energy prices may skyrocket. In short, the industry will hit a brick wall.More likely, FERC will figure it out. In this case, companies such as Exelon, NRG, AEP and FirstEnergy may see happier top and bottom lines.

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