Forward Reliability Markets: Less Risk, Less Market Power, More Efficiency

A forward reliability market is presented. The market coordinates new entry through the forward procurement of reliability options—physical capacity bundled with a financial option to supply energy above a strike price. The market assures adequate generating resources and prices capacity from the bids of competitive new entry in an annual auction. Efficient performance incentives are maintained from a load-following obligation to supply energy above the strike price. The capacity payment fully hedges load from high spot prices, and reduces supplier risk as well. Market power is reduced in the spot market, since suppliers enter the spot market with a nearly balanced position in times of scarcity. Market power in the reliability market is addressed by not allowing existing supply to impact the capacity price. The approach, which has been adopted in New England and Colombia, is readily adapted to either a thermal system or a hydro system. 1 Understanding the generation adequacy problem The reliability of a power system depends on how it is operated in the short term (security) and medium term (firmness), but if there is not enough generating capacity, it will not be possible to serve all load and achieve security and firmness. In this way, adequate generation is the most fundamental reliability issue, and it is also the one most distant from the spot market because it is the most long-term aspect of reliability. This paper focuses only on the long-term issue of generation adequacy, but the importance of the prescribed reliability-options approach to adequacy is that it facilitates the solution to the three worst problems of contemporary electricity markets: investment risk, market power and inefficient pricing. Contrary to conventional wisdom, the level of generation adequacy is not much of a problem because marginal generating capacity is relatively inexpensive when compared with other costs of delivered energy, and because, as with most optima, the derivative of net benefit with respect to capacity is zero at the optimal capacity level. For example, an extra 10% of capacity increases capacity costs by much less than 10% because peaking capacity is by far the cheapest kind of capacity, and adding peak capacity does not increase fuel costs, transmission costs or administrative costs. As a consequence, increasing total capacity by 10% will cost consumers only, perhaps, 2% extra. But there is some benefit to the resulting extra reliability. So the loss of net benefit is less than 2%. A good regulatory approach is unlikely to overshoot by more than 10% on average, and the best market-based approach will not be perfect. Hence, the net benefit of improved adequacy from any market-based approach is necessarily quite small—likely less than 1% of total retail cost. The true cost of the adequacy problem has been the distortion of 1 For a more complete explanation of reliability see the paper in this issue by Batlle and Pérez-Arriaga. 2 These problems are actually solved by the capacity-market / reliability option design provided the rest of the market design is reasonable and the market does not have structural problems such a high supplier concentration.