Far from perfect but the best there is 

Winston Churchill famously said, “Democracy is the worst form of government, except for all the others.” Despite its many flaws, that is how its supporters characterize PJM’s capacity market. As proof of its appeal, countries as far away as the UK, Germany, So Korea, to name a few, have examined the design features of PJM with the hope of borrowing some of its best features for adoption in their own markets.

According to Joseph Bowring of Monitoring Analytics, PJM’s market monitor, the early wholesale power market designs in the US, including PJM, replicated the efficient dispatch of a tight power pool, but did not address the sources of revenues to cover the costs of investment in new and existing generation. Consequently the early designs did not provide adequate signals for sustainability nor fully resolved the missing money problem.

More recent capacity markets have largely solved the resource adequacy problem but continue to suffer from other imperfections as further explained in a 2014 article published by Joe Bowring in Economics of Energy and Environmental Policy (EEEP), Volume 2, Number 2, an academic journal. The resolution of these remaining design issues – currently under consideration – is critical to the continued success of the PJM market, and capacity mechanisms in general.

Talking to EEnergy Informer, Bowring explained that PJM implemented its Reliability Pricing Model (RPM) in 2007 to address the missing money issue, and more important, to provide price signals that would provide adequate incentives to build new capacity when and where it was needed without regulatory intervention.

At its core, RPM included the definition of capacity as an annual product, a must offer requirement for all capacity resources and a must buy requirement for all load. RPM recognized that capacity is a physical product requiring performance incentives and a net revenue offset as the link between energy and capacity markets. The RPM design included a sloped demand curve (graph on page 19) with defined inflection points, a competitive 3-year forward procurement auction, a locational market definition plus stringent market power mitigation rules, a task handled by Monitoring Analytics.

According to Bowring, although the basic elements of RPM model were sound, there were design features that distorted prices or did not reflect market fundamentals. Additionally, some of RPM’s design features resulted in unintended outcomes leading PJM to introduce ad hoc modifications to rules, which inevitably led to their own unintended consequences.

PJM’s demand curve: Administratively defined: Demand Curve for 2017/2018 RPM Base Residual Auction

The lessons learned in the evolution of the PJM capacity market illustrate issues that are shared across all wholesale markets. An exogenously imposed administrative reliability requirement has generally been interpreted to require the ownership of, or contracts for, capacity in excess of expected peak loads.

In case of PJM, the reserve margin requirement resulted in a level of capacity greater than would have been the case in an energy only market. The result was lower energy prices for all generators and a shortfall of net revenues compared to the annualized costs of building a new generating unit. These deficiencies have led to criticisms from disgruntled generators, including AEP (preceding article).

Bowring, however, believes that capacity markets can be an effective part of wholesale electricity markets but concedes that “it is important to get (the) … design right to permit capacity market prices to reflect the actual underlying locational supply of, and demand for capacity.”

PJM’s recent capacity market prices set at the latest auctions: History of PJM capacity prices: 1999/2000 through 2016/2017

In designing a capacity scheme, Bowring says a number of basic questions must be asked and answered including the following:

•  What problem is the capacity market intended to solve?
• How is that problem addressed in the current market?
• What are the design features of the proposed capacity market?
• What is the expected impact of the scheme on existing generation and on customers?

Any capacity market must include detailed analysis of key market issues including:

• Target reserve margin;
• Nature, pattern and geographical distribution of demand;
• Shape and rationale for the demand curve;
• Requirement to offer supply and the nature of supply offers;
• Locational requirements, definitions of the market, performance and investment incentives; and
• Appropriate market power mitigation rules plus a vigilant market monitor to make sure all participants abide by the rules.

PJM’s capacity market is far from perfect, but if you insist on having one, it probably is the best you are going to get.

Published Originally in EEnergy Informer: The International Energy Newsletter October 2014 Issue.