In New Hampshire and all of New England, the biggest threat to economic development that no one knows about is a looming energy crisis but not the one you think of. Everyone talks about the rising cost of gasoline but we are quietly and rapidly running out of electricity and face the threat of rolling blackouts as soon as 2008. New England is producing enough electricity today but the electricity needs of consumers are growing and a thriving economy will make those needs grow even faster. In a few short years, the capacity of existing power plants will no longer be enough to meet demand. Because new plants (and many existing plants) are not economically viable under current structures, the building of new plants has dried up.
Current market structures aren’t working to provide New England enough electricity even to meet today’s demands. Because of market failures, regional and federal regulators have instituted a stopgap measure (Reliability Must Run contracts) to prevent plants from closing. However, that stopgap approach does nothing to provide for the future. To address market failures and try to provide for future energy needs, New England’s electric grid operator, ISO-New England, has a proposal to replace the current patching efforts and provide incentives for the additional capacity New England’s economy needs. It is known as the Locational Installed Capacity Proposal (LICAP) and it is before the Federal Energy Regulatory Commission.
The looming crisis threatens New Hampshire and all of New England’s economy and is based in the complicated markets that ensure businesses and consumers have the electricity we take for granted. The market structures in electricity are quite different from a classic marketplace. Electricity is not a marketed good like, say, tomatoes. A producer doesn’t open a stand selling his product inventory bit by bit to people who may use it that day or next week. Electricity, in general, can’t be stored and must be readily available, in stock, every minute. Flipping on a light switch or running industrial machinery is not a negotiated shopping decision that uses a can of tomatoes from the root cellar. Rather, the electricity must be available to all customers at all times whether they decide to use it or not.
In the six New England states, making sure the needed power is produced and available is the responsibility of the regional grid operator, ISO-NE (Independent Service Operator, New England). In essence, it is the responsibility of the grid operator to make sure sufficient power is available (“capacity”) and generated by plants to meet the expected demand. They also ensure the produced power is transmitted over the electric grid to suppliers like your local utility.i
For enough power to be available to serve the market, it must both be generated and also be able to be transmitted to the appropriate location. In general, New England must be able to produce as much power as it uses. New England imports a small amount of power, mostly from Quebec, and exports an insignificant amount of power to New York. Net imports accounted for only 3.7% of energy use.
However, even within New England, transmission constraints – essentially outdated infrastructure – make it difficult to move some excess power from where it is generated to the location that needs more supply.ii These constraints make the location of some power capacity within New England more important than others.
New England as a whole is running out of power and some regions already have. Although New England set two new records for power usage this summer, existing resources – if none cease operations – are enough to support current use. However, electricity usage is growing by about 500 MW each year, the production capacity of one good-sized power plant. The grid operator estimates “that New England will be short of capacity in the 2008-2010 timeframe depending on weather and economic conditions.”iii Hotter days demand greater power and a growing economy will accelerate the need for more power. Given that it takes 2 to 3 years to bring a new power plant online, the capacity shortage will occur just after a plant would begin operations if development began today. In addition, Southwestern Connecticut, the most serious problem zone in New England, will have a shortage earlier, perhaps as soon as next year. Already the grid operator has been forced to develop temporary contracts for power to ensure reliability.
Without enough electricity, the grid operator would be forced to institute rolling blackouts as a form of rationing. Businesses considering expanding in or moving to New Hampshire would almost certainly avoid the unreliability of rationed electricity. Consider trying to run a retail center or major industrial facility with periodic blackouts.
This electricity shortfall occurs as new investment in generation (supply) has dried up. A new power plant will take 2 to 3 years of development and hundreds of millions of dollars before it comes online. Investment decisions made from about 1996 through 2000 led to almost 10,000 MW of new capacity coming into the system from 1996 through 2003. The new plants were generally cleaner and more efficient than the plants they replaced and account for about 30% of the current total capacity. But after 2,786 MW came online in 2002 and 2,949 MW in 2003, only 588 MW came online in 2004. The investment decisions made from 1996 through 2000 produced the new plants but the inability to recover invested capital has stopped any significant new production for years. The grid operator, ISO-New England, notes that investment stopped after price caps were placed on the market in 2000.iv
An analysis in ISO-NE’s annual report graphically illustrates the problem. A power plant receives revenue from two main sources: energy sales (and related services) and the capacity payments made to keep them online and available. Those revenue sources must be enough to cover the operating costs of the plant including the capital investment that was needed to build the plant. According to ISO-NE, a hypothetical new combined cycle gas plant would only recover about 50% of the necessary costs in today’s markets.v In an analysis of “incentives to invest in new generating capacity,” MIT Professor Paul Jaskow cites similar studies from the mid-Atlantic states to conclude that “existing capacity pricing mechanisms do not appear to yield revenues that fill the net revenue gap.”vi If the market does not support an investment’s ability to recover its costs and generate a competitive return, the capital needed to build a plant will not be available. Hence the collapse of investment in new plants.
In short, New England is rapidly running out of capacity and the current payment structure doesn’t support the operating costs of the plants that generate power, new or old. Not only is new power not being developed but existing capacity is in trouble as well.
The current approach to keeping enough plants open to meet demand is best described as a patching operation, a stopgap measure designed only to triage an unsustainable system until a solution can be put in place. It addresses a critical short-term problem but is not a workable system for the future.
New England’s power system relies increasingly on a system of “Reliability-Must-Run (RMR)” contracts. The number of plants that would choose to stay open while working to fix the market is not enough to ensure reliability – that the system has enough electricity to meet the current needs of businesses and consumers. Under the RMR contracts, some power plants that can’t afford to stay open are told by the regulators they must remain open to ensure reliable energy capacity. In exchange, the plant is given larger payments that allow it to cover its operating costs. The existence of such contracts is an explicit admission that the current capacity market does not allow a power producer to be financially viable. RMR contracts began as the economics of power plants became apparent a few years ago. In 2004, RMR contracts doubled from $82 million to $165 million covering 2,342 MW. In the first part of 2005, the amount of capacity covered increased by 20% to 2,707 MW. An additional 4,625 MW are awaiting approval, a total that would more than triple the amount of capacity under reliability contracts.vii
So, under the current system, capacity payments don’t cover the operating costs of a new plant. Some plants – a larger and larger number – are given supplemental payments to keep them from closing. Others struggle economically under the inadequate capacity payment structure. Without a new structure, new power plants needed to address the growing demand won’t be built and the patchwork of plants operating under reliability contracts, already exploding, will continue to swell. The scope of reliability contracts has already grown from a few exceptions to a system with one group of producers operating under the RMR system and a second group, those who have not yet received RMR approval, being treated dramatically differently.
To meet the needs of electricity users, ensure the viability of power generation in New England, and replace the stopgap RMR system, ISO-New England proposed a new system called LICAP – Locational Installed Capacity.viii Essentially, the LICAP system increases capacity payments to improve the financial viability of plants but does so in a targeted way. Capacity payments are higher in areas with greater need than they are in areas with sufficient power. This market mechanism recognizes an economic reality: new generation is in greater demand and therefore more valuable in some areas like Southwest Connecticut that don’t have enough power than it is areas with a surplus of power, like Maine. For that reason, the new proposal also divides New England into five zones for this purpose: Southwest Connecticut, Rest of Connecticut, Northeast Massachusetts, Maine, and the rest of New England (including New Hampshire, Vermont, Rhode Island, and parts of Massachusetts).
In addition, plants are rewarded to the extent that they contribute to ensuring reliability – the ready availability of power. Just as needs are more critical in certain areas, there are also greater needs during certain times. Capacity payments are structured along a demand curve that reflects the realities of market needs at a given time.ix
Additionally, and importantly, actual energy revenues are deducted from capacity payments. Capacity payments are designed – like the current reliability agreements – to bridge the gap between energy revenue and operating costs. As revenues increase, those bridge payments ought to be smaller.
Shifting part of the generation cost of electricity into capacity and reliability should encourage a diversity of fuel sources reducing the economically risky reliance on any one source. A massive build up of gas plants when gas was inexpensive backfired as natural gas prices soared. A capacity incentive that cuts across fuel sources helps encourage a diversity of fuel sources (wind, nuclear, coal) limiting the economy’s exposure to spikes in any one fuel.
One objection to the plan is that while LICAP improves the economics of operating a plant, it does not guarantee new development. Well, of course not. No structure can force private investors to do anything. New structures can merely eliminate the obstacle that is preventing investment. Through RMR payments, we have recognized that the current capacity market payments prevent investment in new generation and forcing us to keep plants open through patchwork agreements. A new, economically viable system will keep some plants from closing and eliminate the barriers to new investment. Having a stable and secure revenue stream is the most important part of securing financing for plant construction.
The overall cost of the plan has been the subject of the most strident arguments. As the discussion of capacity markets has developed over the last two years, most observers have come to the conclusion that something must be done. The cost of doing nothing is incalculable.
Early estimates included claims by New Hampshire’s utility regulatory staff that costs could be as high as $10 billion over five years.x A year later those early estimates are seen as too high and uncorrected for existing expenditures and the growing RMR payments. ISO-New England has estimated the costs at $2.3 billion over five years after adding the cost of the new program and subtracting existing payments. A better study by the New England Power Generators Association details the increased cost of the program at $2.5 billion over five years after deducting current costs like the existing capacity program and current RMR payments.xi Even that estimate is probably too high as it maintains current RMR costs. As we’ve seen, stopgap RMR payments would increase dramatically in coming years if no changes were made.
The current system cannot and will not supply enough electricity to meet the needs of businesses and consumers. Demand is increasing and new plants cannot be built because the current market structure will not cover investors’ costs. Investors, being rational, will invest elsewhere. What’s more, current electricity is being propped up by an ever increasing series of stop gap payments being made to require plants to stay open because New England won’t have enough electricity without them – the literal meaning of reliability-must-run. The status quo is untenable and change is required.
1 This is a very simplified version of the complex operations performed by the regional transmission organizations. For a more comprehensive look at the services and obligations of ISO-NE, see their annual report: ISO New England 2004 Annual Markets Report, 15 July 2005, http://www.iso-ne.org/markets/mkt_anlys_rpts/annl_mkt_rpts/index.html.
2 There is a more detailed analysis of infrastructure problems in the ISO New England annual report. For a very accessible description of some of the economic costs and opportunities posed by transmission infrastructure see Dr. Lisa Shapiro, “Transmission Transition: Toward an Efficient Electricity Grid,” 2002 October (for publication in Energy User News but available on the web), http://www.gcglaw.com/resources/energy/transmission.html.
3 See ISO-NE Response Letter to the Connecticut Congressional Delegation on LICAP, 24 August 2005, http://www.iso-ne.com/pubs/pubcomm/corr/2005/ct_delegation_letter_8_24_05.pdf.
4 See The ISO-NE response letter to New England Governors on LICAP, 25 July 2005, http://www.iso-ne.com/pubs/
5 See ISO New England 2004 Annual Market Report, p. 111-112.
6 Paul L. Jaskow, “Markets for Power in the United States: An Interim Assessment,” 2005 August, forthcoming in The Energy Journal. http://econ-www.mit.edu/faculty/download_pdf.php?id=1219.
7 See ISO New England 2004 Annual Markets Report, p. 78-79.
8 The ISO proposal is based on principles outlined in Peter Cramton and Steven Stoft, “A Capacity Market that Makes Sense,” forthcoming 2005 August, Electricity Journal.
9 The details of a demand curve and the principles behind are described in great detail in Cramton and Stott’s paper. While the nuances of the curve are open to some discussion, they are beyond the scope of this explanation.
10 See comments of New Hampshire utility commissioners and Office of Consumer Advocate for example: http://www.oca.nh.gov/Docs/ISO%20press%20release%2011-9-04.pdf.
11 NEGPA Technical Bulletin: “Estimating the Cost of LICAP,” 19 July 2005.