Free markets are wonderful when they work. They are efficient in pricing energy for North America's 10 Regional Transmission Organizations (RTOs). But using the same technique to price other utility services has failed and is causing a rift between the states, the federal government and the RTOs.
The RTO market-based approach has failed New Jersey in three ways. First, an RTO is not designed to deliver the best possible price for energy. Second, the RTO's market-based approach for capacity discourages investment. Third, the RTO attempts to preempt states' sovereignty.
RTOs, like PJM Interconnection, determine energy prices using a uniform price auction. In this type of auction, all units are traded at a uniform market-clearing price, where the price for energy will always be pegged at the most expensive resource clearing the auction.
The alternative is used by regulated states where the price for energy is indexed to the auction's average price. The average price will always be lower than the market clearing price and, therefore, regulated states price energy lower than deregulated states.
The state is not the only party affected by PJM's pricing policies. Generators are also squeezed. The market-based approach provides each generator with different gross margins. Those with low production costs will earn the highest gross margins. The energy market ignores the generators' capital costs and punishes the most flexible plants, intermediate and peaking facilities.
To manage the hourly swings, PJM needs intermediate and peaking facilities even though they earn thin gross margins in the energy market. So PJM and other RTOs will pay rent or a capacity payment for their generators who clear a capacity auction (some grids do not pay for capacity). The capacity markets ignore plant efficiencies and reward generators with lower capital costs. Specifically, for a new build, the capacity markets reward gas-guzzling, turbine generators over solar farms.
PJM's market approach toward capacity has two problems. The most troublesome issue is the terms. Most generating assets are 30-to-50 year investments. PJM's commitment is a maximum of three years. In this situation, investors are not hedged; they are being asked to speculate on future capacity auctions. Third-party investors do not speculate on power plants.
The second problem with capacity payments is fungibility. The Federal Energy Regulatory Commission (FERC) and PJM's market-based policies assume power plants are fungible. They are not. There are at least five categories of power plants: (1) must-run plants, (2) base-loaded plants, (3) intermediate plants, (4) peaking plants and (5) plants in reserve. These categories rarely compete with each other because they serve different functions. Surprisingly, the FERC and PJM treat these broad classes as if they were fungible commodities. It is a fundamental and unexpected misunderstanding of power plants and commodities.
Capacity auctions reward peaking and reserve plants, which conflicts with energy auctions that reward mostly base-loaded plants. Combining these separate auctions creates a financial mess for generators and for states. As a result, few developers will build new generation in RTO markets.
The only companies that can win in this scheme are independent power producers who own depreciated assets. Even some of these companies struggle to reach the bottom line. Just check the last several quarters for Calpine (CPN), GenON Energy (GEN) and Dynegy (DYN); you will notice horrible earnings.
New Jersey figured this out. In 2010, the state decided to bypass PJM's capacity markets and provide the financial hedge investors had been requesting. According to Reuters, "The state has blamed PJM's capacity and other charges for adding over $1 billion a year to consumers' power costs." Last January, Governor Christie signed a bill providing state-backed, 15-year power purchase agreements for 2,000 new megawatts. That is when the war between New Jersey, PJM and the FERC began.
The FERC immediately tried to scuttle New Jersey's plans by siding with PJM. FERC and PJM argue that New Jersey's building 2,000 new megawatts disturbs PJM's capacity markets and lowers incumbents' gross margins. In addition, the FERC does not want individual states breaking away from federally approved policies.
The state believes that it is their duty to protect their ratepayers. Further, the state does not believe it forfeited its sovereignty when PJM became the regional transmission operator.
This issue is not limited to New Jersey. Reuters reports other states with competitive power markets are watching the battle closely, because they too are struggling to find ways to build new generation.
This issue may reach the crisis stage. The FERC is now in the position of regulating assets that were once in the domain of state utility commissions. States found themselves forfeiting their sovereignty to regulate intrastate commerce. And the markets, as they have been constructed by FERC, are discouraging investment in power plants at a time when new power plants are desperately needed.
