Do Pay-for-Performance Capacity Markets Deliver the Grid Resiliency Outcomes We Need?

This post originally appeared on Green Tech Media here.

How to design capacity markets to ensure a flexible electricity mix

Apr 28, 2015 by Mike Hogan, Michael O’Boyle, and Sonia Aggarwal

Competitive wholesale power markets are designed to sustain needed investment through market participants hedging risks in response to transparent pricing in the energy and ancillary services markets.

But in practice, it’s been a challenge to realize market prices fully reflective of actual market conditions. Is the money and risk exposure needed to drive investment “missing” from energy markets?

Several market operators have instituted capacity markets to bridge the gap between revenue available from energy markets and the all-in cost of desired capacity. Capacity markets offer commitments (short-term relative to most investment timescales) to make fixed payments for the right to call on the resource when needed.

Capacity markets “levelize” a portion of expected revenues, which otherwise would be volatile and difficult to predict. They also transfer some responsibility for determining the amount and type of investment needed from the market to a central administrator. But will they deliver the outcomes needed for the energy system transition?

Capacity market challenges exposed during Polar Vortex

System capacity requirements in a given period are a function of maximum expected demand, and capacity markets have traditionally been designed on that basis. Customer expectations require these resources to perform not just during peak demand, but also under other system stress conditions.

This imperative was evident in the Northeast and Mid-Atlantic during the 2013-2014 polar vortex when reliability was placed at risk because a great deal of committed capacity failed to show up. This resource flakiness was largely the result of weather-related plant outages combined with fuel delivery problems, failures that existing capacity markets largely do not address.

System operators have proposed different market revisions to improve the resource mix and boost reliability, but it’s unclear if these reforms will keep up with system needs in a time of transition while promoting affordable, clean electricity.

Is pay-for-performance reform the answer?

System operators affected by the polar vortex (PJM, NYISO, ISO-NE) have each proposed market reforms to address resource performance. NYISO, which has a capacity market, has concentrated on improving energy market pricing. PJM and ISO-NE have proposed adding “pay-for-performance” capacity market mechanisms that increase capacity payments for resources performing during all peak and emergency hours, not just the annual peak, while penalizing underperforming resources. After these changes, non-performance risks will fall more on capacity resources and less on system operators and consumers.

The Federal Energy Regulatory Commission (FERC) recently approved NYISO’s energy pricing revisions, approved ISO-NE’s capacity market revision in 2014, and is currently considering PJM’s proposal. ISO-NE split capacity payments into an initial payment, followed by a performance payment or penalty. As before, the marginal offer sets the clearing price for base capacity at the time of the auction and higher offers are rejected. But now when these resources enter the system three years later, total payment is adjusted for performance via additional payment or penalty.

The performance payment or penalty results from how well resources actually perform during emergency, summer-, and winter-peak conditions (“scarcity events”) relative to their original capacity offer. Penalties paid by underperforming resources cover higher costs paid to overperforming resources to maintain system balance.

Resource coupling in PJM’s capacity performance proposal

PJM’s Capacity Performance proposal adopts a similar framework to ISO-NE but introduces “resource coupling” in an attempt to level the playing field. Capacity market “resource coupling” empowers seasonal or variable resources like demand response, variable generation, and energy efficiency to “couple” their offers with resources that complement their operational profiles. For example, wind turbines can combine with solar plants, energy storage, or demand to form a single PJM capacity market offer.

Some public interest organizations would prefer FERC reject PJM’s proposal, asserting the deck is unfairly stacked against renewable resources and demand response, and the proposal is an overly broad and costly solution to a relatively small problem. Seasonal or variable resources’ ability to couple offers with other resources mitigates some inherent disadvantage, but coupling benefits are dampened by the restrictiveness of combining smaller sets of resources instead of capitalizing upon diversity in the full portfolio of system resources.

PJM’s proposed capacity performance reforms may meet the system’s primary unmet need of dependable capacity, but the broader challenge remains: these markets have long-term flexibility needs, and even revised capacity mechanisms may prove too rigid to adapt efficiently to a rapidly evolving power system.

How will capacity market changes affect resource mix?

Under the old market structure, resource owners offered capacity into the market based on the difference between all-in costs and expected revenue from energy and ancillary service markets, with the risk of “normal” operating problems borne largely by consumers.

But generators must now account for substantially higher risk of non-performance penalties during scarcity events, which will grow more frequent and less predictable as more variable generation connects to the system and as extreme weather events increase due to climate change. Additionally, resources not directly involved in capacity markets (either because they do not offer their resource or because their offers are too high to be selected) can still be rewarded for providing electricity during scarcity events.

This makes the new structure less attractive for seasonal resources or those at risk during scarcity events­. Conversely, resources available year-round and in extreme conditions become more attractive in the “pay-for-performance” structure, incentivized to secure fuel supplies, add dual-fuel capabilities, and protect operations from extreme weather events like deep freezes or drought. ICF predicts this will raise capacity prices for ISO-NE but ultimately drive down wholesale energy prices and increase overall system efficiency and reliability.

These changes will improve resource availability during scarcity events, but may not deliver greater system flexibility since no explicit reward exists for responding quickly (rather than simply being up and running in advance). The Analysis Group concluded the most significant response in ISO-NE would be adding dual-fuel capability to existing gas plants, doing little to increase system flexibility.

In fact, driving down wholesale energy prices and suppressing their variability (by replacing them with fixed capacity payments) reduces incentives for flexible resources whose values rely heavily on short-term price volatility — particularly demand response and energy storage.

Implications for grid flexibility and resource adequacy across America

So how will capacity market reforms impact the rest of America? Pay-for-performance capacity markets aren’t the only way to ensure resource adequacy, and they do not directly favor a significantly more flexible resource mix. Energy and capacity markets can and should be reformed to drive efficient investment in more flexible, reliable resources.

Smart proposals are tackling this issue. Mike Hogan, author of “Aligning Power Markets to Deliver Value,recently outlined how to value flexibility in energy and ancillary service markets by fully pricing scarcity and further opening markets to non-traditional providers.

Recently approved NYISO reforms focus on improving shortage pricing in energy markets, in contrast with the focus on capacity market reforms in PJM and ISO-NE. The Electricity Reliability Council of Texas (ERCOT) has also proposed reforms to its energy and ancillary service markets valuing the properties provided by flexible resources. Outside restructured market areas, planning will continue playing an important role ensuring adequate system flexibility.

Tradeoffs exist between these market solutions. Capacity market approaches may be simpler to administer, but they have thus far focused on having adequate resources to meet peak when we also need increased system-wide flexibility. On the other hand, allowing energy market prices to fluctuate and refining ancillary service markets may increase system-wide flexibility, but may prove too complex or too politically unpalatable. Energy decision-makers should watch to see which kinds of market reforms best facilitate the transition to an affordable, reliable, clean electricity system.

America needs a more flexible, resilient resource mix. As weather patterns change and variable resources increase their share of our electricity supply, efficient markets should adequately reward flexible resources complementing low-marginal-cost energy from variable resources at the lowest possible cost.

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Mike Hogan, Michael O’Boyle, and Sonia Aggarwal represent America’s Power Plan. Thanks to George Katsigiannakis, Jennie Chen, and Eric Gimon for their input on this piece.  The authors are responsible for its final content.

The views expressed in this blog are those of the authors, and do not necessarily represent the views of the Sustainable FERC Project or Natural Resources Defense Council.

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