By Rich Heidorn Jr.

WASHINGTON — Four Ph.Ds. joined in a tag-team debate last week on the virtues of scarcity pricing versus capacity markets in a panel discussion-cum-economics seminar at the Energy Bar Association’s Annual Meeting.

It’s unlikely any of the combatants, who have often sparred each other, came away with any different opinions. But the repartee was no less sharp for the familiarity.

William W. Hogan, research director of the Harvard Electricity Policy Group, staked out the energy market-only pole of the debate, repeating his argument that capacity markets are unnecessary if the energy and ancillary services markets “get their prices right.”

“Life is too short to spend your time trying to perfect capacity markets,” Hogan said.

PJM Market Monitor Joe Bowring said Hogan’s vision is unrealistic. “It’s easy enough to say in a theoretical world that scarcity pricing should take care of everything. But we have yet to see that demonstrated in the real world,” he said.

Administrative Determinations

Bowring also attempted to puncture any notion that scarcity pricing is much simpler than capacity markets.

“Let’s not pretend that scarcity pricing is some automatic market mechanism that will simply take care of problems without an intervention,” he said. “It is equally administrative as capacity markets — just different. You still have to determine … the appropriate net revenue. And it’s a lot trickier than it sounds.”

Sam Newell, a principal with The Brattle Group, challenged Bowring’s assertion.

“Although the pricing in an operating reserve demand curve [ORDC] is administratively determined, actually there’s less administrative determinations than in a capacity market because you’re just saying what the prices should go to under certain real-time operating conditions.”

In a capacity market, he continued, “You have to decide what is the reliability concept you’re meeting. Is it summer peak? … You have to decide how different resources can qualify to meet that and so there’s a lot more administrative determinations.”

Concern over Volatility of Revenue Stream

David Patton, whose Potomac Economics provides monitoring services in MISO, ISO-NE, NYISO and ERCOT, expressed concern over the volatility of generators’ revenue streams under scarcity pricing.

“Unless you’re willing to price shortages at $200,000/MWh, you’re not going to meet your planning requirements with the energy market alone,” he said.

“Shortage pricing is not like a capacity market where you’re going to get a level of revenue that might fluctuate by 10 to 20% a year. With shortage pricing, you might get 10 years of revenue in one year and then the other nine years the generators are going to think they’re going bankrupt.”

This is because shortage prices “increase exponentially when you get unusually hot weather and unusually high loads or unusually poor generator performance,” Patton said. “Look at ERCOT in 2011 and compare the number of shortage incidents you had in that year to the prior 20 years.”

That could lead to constant tinkering, Patton said. “You don’t want policymakers to jump in when it’s not producing revenues for a number of years. You also don’t want them to jump in in the year when it produces $20 billion of revenue,” he said. “Because that’s what you signed up for.”

Bowring added another potential negative consequence.

“What will happen if you go through eight years of very low revenues under scarcity pricing … and a significant number of units decide to retire because they can’t see into the future? They don’t know if [in] the ninth or 10th year there’s going to be $20 billion. They retire if the revenues aren’t adequate.

“There’s a level of risk associated with scarcity pricing that differs from capacity markets, which is why the optimum might be to have more revenues in the scarcity pricing but not 100% of expected revenues,” Bowring said.

Locational Issues

Bowring said he agreed with the need for scarcity pricing but said it “is done very ineffectively now” in PJM because the ORDC hasn’t been made “adequately locational.”

“Scarcity doesn’t work if it’s an aggregate, because you can be long aggregate in PJM or other big RTOs or ISOs and be very short in particular places,” he said.

Joint Optimization

ERCOT has a different problem, said Patton: a failure to jointly optimize the energy and shortage markets so that the ISO can price transitory shortages.

“We perpetually undercompensate units like pump storage units, combined cycle units. They’re way more valuable for reliability because they can ramp fast,” he said. “But if you don’t reveal the true state of the system in every five minutes you undercompensate them.”

Market Mitigation

Hogan sought to allay what he called a misconception that shortage pricing is incompatible with price caps and other market mitigation measures.

“The advantage of this operating reserve demand curve … is that prices go up because of the scarcity of reserves. They don’t go up necessarily because of high offers by the generators. So it is completely compatible to have offer caps — which are dealing with market power problems with generators — that are set by their variable cost of operation. You could have a $500 offer cap, say, on generators and then you have the operating reserve demand curve that is setting the price and the price is $3,000/MWh.

“All of the market mitigation … continue to exist. You don’t have to get rid of that,” he continued. “If you don’t have the operating reserve demand curve, offer caps depress the price and do all kinds of bad things.”

Changing Conditions

Newell said scarcity pricing may be better suited to respond to changes facing the industry.

“With variable energy resources suppressing energy prices — creating over-generation sometimes on the one hand, ramping shortages on the other — the nature of reliability is changing, and it’s not just about summer peak.

“And that is another reason why I want to second what Dr. Hogan said. It is better to get the prices right — reflecting real-time conditions and telling the market what you need, when you need it — rather than just having a narrow administrative idea of reliability. So I would like to see more money moving into the energy and ancillary services markets and out of the capacity markets.”