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It’s Not Easy Being Blue

A recent Federal Energy Regulatory Commission decision illustrates the complicated dance between states and the federal government on climate policy.

According to some energy aficionados, natural gas is the “blue bridge to the green future.” Combined cycle gas turbine (CCGT) power plants are highly efficient and emit about half the carbon dioxide per unit of electricity as coal plants, plus natural gas prices have fallen dramatically recently. Natural gas surpassed coal as the primary source of electricity in the US in 2015 and hasn’t looked back since.

But, things are not so easy for natural gas power plant owners these days. My husband works for Calpine, which operates 80 mostly natural gas plants around the country, so I see firsthand the challenges he wrestles with. A recent case before the Federal Energy Regulatory Commission (FERC) highlights the difficulties for natural gas plants, particularly those that rely on compensation from competitive wholesale markets.

Capacity Markets Fall Short

Here’s the basic story. Like many wholesale electricity markets in the U.S., the PJM Interconnection – the regional electricity market centered in Pennsylvania, New Jersey and Maryland – has a capacity market. Capacity markets are designed to ensure that there are sufficient resources on the electricity grid to meet future peak demand. Utilities and other electricity suppliers are required to purchase enough capacity to cover their expected peak demand and then some.

In a textbook economics world, capacity markets would not exist. Instead, during times of peak demand, spot market prices for electricity would go up until the market cleared. They might periodically be very high, but if firms like Calpine anticipated these high prices, they would have the right incentive to build capacity to be in the market during the peak periods.

But, in the real, not-textbook, world, spot market electricity prices are capped and other services are not priced appropriately. So, most regional electricity markets include capacity markets. (I am not taking a stand on whether Texas, which does not have a capacity market, conforms to textbook economics or isn’t a part of the real world!)

A natural gas power plant in Texas

Many natural gas power plants earn a good chunk of their revenue through capacity markets. In 2017, revenues from the PJM capacity market would have accounted for almost 40 percent of the earnings for a theoretical, new CCGT plant. (The remaining 60 percent came from the energy and ancillary service markets.)

Here’s the rub. The total revenues – capacity plus energy plus ancillary services – are not high enough to cover a new CCGT power plant’s costs. In the figure below, the orange line represents the capital cost of operating the new plant spread over 20 years. (The calculation is re-done every year, so the line is declining over time as the levelized costs of the new plant change.) The dots reflect the net revenue the plant would have received in various sub-locations within PJM, after subtracting out variable costs, like fuel costs. In 2017, the plant wouldn’t cover its costs in 17 of 20 locations – not a good situation if the aim is to ensure that there’s enough capacity in the market. Other years have been better, but there are areas where the plant would have been losing money consistently for each of the 9 years.

Source: PJM State of the Market, Chapter 7

State Intervention in Markets

Calpine argues that part of the insufficient revenue problem is that capacity market prices are suppressed by bids from power plants that receive either implicit or explicit subsidies. For example, renewable plants built to satisfy state renewable portfolio standards receive implicit subsidies. I see Calpine’s logic – they’re basically trying to make money selling lemonade in a neighborhood full of kids whose parents buy them adorable stands and pay for the Newman’s Own.

Two years ago, Calpine lodged a complaint with FERC, arguing that PJM needed to fix the capacity market to account for the subsidized (parent-supported) plants. Last month, FERC issued an order agreeing with Calpine.

A lot of the subsidies are for renewables, but lately nuclear and other types of plants got into the subsidy game. The FERC decision lists:

  • 1,400-3,360 MWs of nuclear generation eligible for zero-emission credits under a law recently enacted in Illinois,
  • 3,360 MW at the Salem and Hope Creek nuclear facilities that would receive similar payments under legislation recently enacted in New Jersey,
  • 1,350 MWs of off-shore wind generation required under procurement programs under existing law in Maryland (250 MW) and New Jersey (1,100 MW), and
  • 5,000–8,000 MWs of generation from various renewable resources eligible under RPS programs in various PJM states, including New Jersey, Delaware, and the District of Columbia.

If the Trump Administration succeeds in subsidizing coal plants (as Jim, Max and Meredith have blogged about), gas plants may be the only ones without subsidies.

FERC Is from Mars, States Are from Venus

What does this mean for CCGT owners like Calpine? They own existing plants, so their costs of continuing operations are lower than the costs reflected in the orange line in the figure above since most of their capital costs are now sunk. If revenues get too low, though, they won’t even cover their going-forward costs and will be forced to shut down. Plus, when they decided to build their plants, they presumably expected market revenues would cover their operating and capital costs.

FERC is required to ensure that wholesale power prices are “just and reasonable.” In this case, they interpreted that to mean that Calpine had a point. FERC prescribed a way for PJM to adjust its capacity market so that subsidized plants don’t drive prices down as much. (Of course, we don’t expect the regulator to step in every time reality differs from an investor’s expectations, as Severin discussed here.)

On the other hand, some states are subsidizing renewables and zero-emission nuclear plants to do exactly what Calpine is complaining about – they intend to drive fossil-fuel-fired power plants out of the market as part of the transition to a low-carbon electricity grid. This highlights the difficulty enacting state-level climate policy when FERC and other federal agencies don’t share the same goals.

Other states are taking different approaches to aligning wholesale markets with state environmental policies. For example, New York is considering incorporating carbon pricing directly into its wholesale markets and Energy Institute alumnus Matt White crafted a clever capacity market tweak in New England (Competitive Auctions for Sponsored Policy Resources – CASPR) that basically involved subsidized resources “buying out” unsubsidized resources. FERC has already approved CASPR, and whatever New York implements would require FERC approval.

So, I expect continued friction between FERC and the states and lots of acronym-rich and wonky discussions with my husband. The bridge to a low-carbon electricity system is long and filled with interesting twists and turns.

Catherine Wolfram View All

Catherine Wolfram is the Cora Jane Flood Professor of Business Administration at the Haas School of Business, University of California, Berkeley. ​During Academic year 2018-19, she will serve as the Acting Associate Dean for Academic Affairs at Berkeley Haas. She is the Program Director of the National Bureau of Economic Research's Environment and Energy Economics Program, Faculty Director of The E2e Project, a research organization focused on energy efficiency and a research affiliate at the Energy Institute at Haas. She is also an affiliated faculty member of in the Agriculture and Resource Economics department and the Energy and Resources Group at Berkeley.

Wolfram has published extensively on the economics of energy markets. Her work has analyzed rural electrification programs in the developing world, energy efficiency programs in the US, the effects of environmental regulation on energy markets and the impact of privatization and restructuring in the US and UK. She is currently implementing several randomized controlled trials to evaluate energy programs in the U.S., Ghana, and Kenya.

She received a PhD in Economics from MIT in 1996 and an AB from Harvard in 1989. Before joining the faculty at UC Berkeley, she was an Assistant Professor of Economics at Harvard.

7 thoughts on “It’s Not Easy Being Blue Leave a comment

  1. As I have posted on several of the blogs here, relying on hourly prices to somehow represent the entire market value for generation is a myth. In capital-intensive industries in which reliability is crucial, policy makers will never let occur the theoretical scarcity pricing prized by economists who insist that this is true value. I first encountered resistance to this notion in a 1996 CEC workshop where the engineers working on modeling the restructured market insisted that the peak scarcity price would be capped at some calculation derived from the cost of building a new combustion turbine. I responded that the market would price at whatever suppliers could bid from a game theoretic basis, which was received with skepticism and the view that the new market wouldn’t survive long with that kind of pricing. After watching the procurement decisions in California over the last 20 years, it’s clear that the true market value is the long-run cost of building a new plant. This is much like house value–with a few exceptions, no one is valuing their house based on the AirBnB rental rate for a bedroom.

    This becomes even more clear when we talk about renewables vs fossil fuel. Renewables, just like a Mercedes, demand a premium over fossil fuels, which are your commodity subcompact. That premium can’t be teased out from tweaks in the hourly market–it shows up in the actual long-term transactions for renewables.

  2. There continues to be, it seems to me, a persistent illusion/delusion that somehow, somewhere, energy (especially electrical energy) is or could be a ‘free-market’ commodity. Maybe – but mark me down as a skeptical cynic – or worse. Even IF one could find the magic wand to make it happen going forward, the fact of the matter is that where we are now is largely, if not completely, due to subsidies and preferential treatment and natural gas is hardly a stranger to that outcome. The main reason we (US) currently have low natural gas prices is fracking which has led to an increasing number of utilities closing down coal-fired electrical generation and even some nuclear plants. But regulation of fracking – even in CA – has been a difficult political process that has certainly left folks whose water supplies have been affected by reinjected fluids wondering if they’ve come out on the short end of the deal even if there’s been a beneficial reduction in carbon emissions.

    If I recall correctly, CA has a fairly minimal oil/gas severance tax and, as another commenter has noted, there’s very little, if any, consideration of externalities. It has been a while since I’ve studies the numbers, but at one point, nuclear power had the largest subsidy per unit of energy delivered (not counting the effects of Price- Anderson), so nukes are hardly new to the game of subsidies.

    It seems to me that in light of the current ‘over-capacity’ in solar/wind generation in CA the immediate and near-term issue is finding a means of storing the electrical energy for use after dark. I keep thinking that Elon is on to something with his batteries (which are apparently being successfully used in western Australia) – but maybe that’s where folks like Calpine should be looking and stop selling lemonade…

  3. This article is premised on bad economic theory. Capacity payments were invented after marginal cost pricing was revealed unable to keep the lights on. It isn’t possible to sell a commodity (kWh) at marginal cost when there are overhead costs in producing it. Almost nothing in the US economy is produced and sold at marginal cost. Agriculture is protected by the USDA and the Farm Bill (at $20 billion plus in many years) is the “capacity payment” for cotton and soybeans. Pharma is protected by patents. Software by copyright. Can you name an industry that is not protected? Read the billionaire Libertarian Peter Theil’s essay in the WSJ titled “Competition is for Losers.” (Or his book on Micro.)
    Start over.
    Deregulatin of electric generation canont work, as “It’s Not Easy Being Blue” reveals.
    Gene Coyle

  4. Your post illustrates why it is critical that the California Independent System Operator (CAISO) NOT become a Regional Transmission Organization as planned under AB813. While CAISO is currently subject to FERC, the Board is appointed by California, whereas an RTO would have an independent Board with representation from the other participating states, many of whom have abundant coal, and motivation to bring such cases alleging subsidies before FERC…
    With regard to your fundamental point about “subsidies” and unfairness to gas–your calculation is not correct until you factor in the climate damage from methane leakage at wellhead and throughout the distribution system, and the “externalities” of fossil fuel consumption paid for in cost of health impact on communities and climate disruption.

  5. The current process of exiting fossil fuels is too slow. There are many areas of the world including the rain forest in Brazil that are burning up with fires. In ten years it may turn into a desert. If you don’t believe this see what’s going on in the new PBS series “Earths Natural Wonders” We have little time to waste. We have to get nearly a zero level of CO2 emissions right now or lose the planet.

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