The theory of capacity markets is simple: in a competitive market, electricity prices for future supply will rise as shortages loom, drawing in competitors to profit by building new generating capacity.

In practice, it may not be working out that way, and simmering discontent over how much consumers are paying for future reliability, and what they’re getting for it, may become open, and bipartisan, rebellion in 2012.

The Local View

Consumers in two congested load areas–in Maryland and New Jersey–are paying increasing surcharges to the so-called capacity markets. New Jersey regulators estimate their surcharges alone will total $11.3 billion by 2015.

But there’s no sign of significant new capacity in those areas, and the two states are charging that capacity markets simply pad utility profits. A study by Synapse Energy Economics in June found 95% of capacity payments in PJM Interconnection, the mid-Atlantic regional grid, have gone to existing generators, not new competitors.

Supporters insist the market-based system will cost consumers less than old state-regulated systems if given time. PJM has surplus generating capacity in some regions and shortages in others, so less expensive means of relieving the congested areas could include new transmission lines and substations, and – if technology advances – power storage.

Judah Rose, Senior Vice President at the management consulting firm ICF International, said the central question for the viability of capacity markets is whether rates will be allowed to rise high enough to work.

As traditionally regulated electric systems gave way to market-based systems in some regions over the last 20 years, market proponents recognized that the system for selling electricity, one day ahead, didn’t provide pricing signals for future needs. No one could get hundreds of millions of dollars in financing for generating facilities meant to work for 30 years based on tomorrow’s prices.

So market advocates proposed capacity markets, special auctions run by grid operators in which suppliers bid to guarantee a certain amount of capacity available in a specific distribution area at a future time. Accepted bids are added to that area’s electricity rates.

The Federal Perspective

The Federal Energy Regulatory Commission (FERC) embraced the system, and PJM–which started auctions in 2007–has the most developed model, but no capacity market goes out beyond five years.

Both Maryland and New Jersey are defying FERC and PJM to get new generation built in their states, in identified congestion spots where consumers are paying the highest surcharges.

In April, FERC changed a key rule at PJM’s behest to frustrate plans approved by the New Jersey legislature and Republican Governor Chris Christie for building up to 2,000 MW under state sponsorship.

Last week, New Jersey regulators recommended the state consider options including creating a power authority outside FERC’s jurisdiction to carry out their plan.

Maryland’s Democratic Governor Martin O’Malley just got Exelon to commit to 120 megawatts of natural gas-fired capacity in the state’s congested zone as a condition of its takeover of Constellation Energy. State regulators are on track to solicit up to 1,500 MW more in January, to be built with 20-year state revenue guarantees.

PJM, backed by FERC, says the states’ remedies will result in generators with unfair advantage who undermine PJM’s market and lower the prices all generators get for their power.

State regulators in the Northeast have chafed against capacity markets since they started, and Ryan Hardy of PA Consulting Group says other states are watching New Jersey and Maryland closely.

Public Power Operators

So are public power operators, according to the American Public Power Association (APPA), which wants capacity markets dumped, FERC’s power market scheme redrawn and long-term contracts, up to 15 years, offered to get new capacity built.

A major problem, said Rose, is the substantial “incongruence” between the cost of using existing capacity and the cost of building new. He noted that much of the country has surplus generation, much of that built years ago under traditional regulation, so capacity markets haven’t grappled with an imminent deficit.

But Hardy noted that overcapacity could evaporate as new Environmental Protection Agency rules tighten coal plant restrictions. Rose said most proposed coal retirements now are in PJM or the Midwestern grid regions, so the need for more capacity may “accelerate” there – and stress-test capacity markets.

Photo Caption: Main Street of Paterson, New Jersey on October 6, 2008.