1. The Convergence of Market Designs for Adequate Generating Capacity Peter Cramton and Steven Stoft 24 March 2006

2.  Converging positive ideas –High spot energy prices send efficient signals –Long-term contracts fight market power –Options reduce risk –ICAP solves the reliability problem –Demand elasticity is wonderful  Exaggerations & ideas attacking good ideas 1.ICAP is anti-market (energy only) 2.Selling options restores the missing money –Requiring long-term contracts is too centralized –High prices mean too much risk / market power –Options are too complex –It’s all too complex! Wait for demand elasticity

3. Fallacy #1: Energy-only avoids administrative intervention Only in markets with responsive demand Current markets cannot price reliability The principal reason for an energy-only market would be prices determined without either administrative price caps or other interventions. – MISO, 2005

4. Quantity (MW) $20,000 $10,000 Interventions 3% 7% Requirement Proposed modifications of the market’s energy demand curve for an energy-only market. Energy + Reserves $30 Price Energy-Only Market “without Administrative Interventions” Market Demand curve

5. Market-driven scarcity (elasticity) revenues Price Quantity Baseload MC Peaker MC Market scarcity revenues are infrequent and brief. Need $80,000/MWh × 50,000MW Price-cap Prices (Admin) No scarcity rent

6. To test if market works with energy-only: Calculate expected rents from high spot prices when installed capacity is adequate Show: market elasticity revenues > missing money ( ~ $ 4 billion)

8. What about a market for reliability? (instead of Energy-Only) It would black out low-value demanders first Right now we can’t do this Later, with fancy circuit breakers, we could

9. How are we doing? 1.Standard energy-only  very administrative 2.Elastic energy-only  not here yet 3.Energy-only + reliability market  not here  But there is another way to attack ICAP: Energy-Only isGood Administrative ICAP is Bad Administrative

10. Comparing administrative transitions Energy-Only –Build the market of the future now –Wait for reality to catch up (real-time meters, etc.) –Easy for the regulator ICAP + High Energy Prices + Options –Stabilize the investment climate now –Protect consumers during the transition –Regulator must adjust market parameters –Easy on market participants

11. Combined approach derived from energy-only High energy prices ($10,000) + Long-term contracts + Done as options + Make them mandatory (backed by a penalty) New energy-only and ICAP approaches: Control reliability administratively Use high spot prices for incentives Differences depend on implementation details Almost ICAP

12. Administrative Details Must load hedge the full adequate level of capacity? Does capacity have to sell load a hedge in order to get the high prices? Yes  complete convergence No  –Unclear investment signals –Market power not well controlled

13. 1987 1995 2000 1994 20042003 1992 1993 1990 1996 2002 1997 1998 1988 2001 1999 1989 1991 0 10 20 30 40 50 60 70 90%95%100%105%110%115% Ratio of Installed Capacity to Target Capacity Scarcity Hours in Year Best-Fit Trend Suppliers did not like look of Energy-Only in ISO-NE after 18 years

14. Fallacy #2 Call option restores missing money Cost of call option at $250 strike California Average Energy Price in 2000

15. Call option does not restore missing money Competitive price just reflects cost Generators give away their scarcity rents Raising the price cap means they must give back more scarcity rents More risk  less investment

16. Purpose of market Induce just enough investment to maintain adequate resources Induce efficient mix and operation of resources Reduce market risk Avoid market power in capacity market Reduce market power in energy market

17. “If all else fails, then do the right thing.” -- Evan Kwerel, FCC 1998: Traditional spot capacity market 2004: Modern spot capacity market –Addresses market power –Addresses performance incentives 2006: Forward capacity market –Addresses market power –Addresses performance incentives –Determines price from the cost of new entry

18. Round 3 Forward Capacity Market Why forward capacity market? Auction mechanics Market power Performance incentives

20. Why forward procurement? New projects compete in advance of entry –Coordinated entry –New capacity sets price directly Long-term commitment for new capacity –Reduced investor risk –Better price signal for new investment

21. Addressing market power Is essential Strong incentive to exercise market power –Existing capacity has substantial sunk costs –New capacity is only a tiny fraction of total –Market is concentrated, especially in zones Any of top-4 suppliers could unilaterally set price Long-term price signals are more stable and efficient if determined from competitive forces, rather than market power

22. Addressing market power New capacity –New capacity bids are not mitigated –Assumes competition for new capacity Delist bids from existing capacity –High bids submitted in advance and posted –High bids cannot set price –Only low bids can set price

23. Performance incentives Comes from scarcity prices in energy market High scarcity prices are hedged –Load is fully hedged by option for 100% of load –Suppliers are hedged by physical capacity Incentive is based on covering your share of load –Generators providing extra are paid extra –Generators providing less are paid less

24. Summary of Convergence Full strength scarcity pricing Mandatory load hedges with options Reliability controlled by capacity market Long-term contracts More demand response –Capacity payments will melt away

25. Virtuous Dynamics Missing money restored Energy price increases Price cap raised Mandatory hedges Demand response increases Un-hedged scarcity revenue up ICAP payments down Introduced with Forward Capacity Market: Over time: