Letter to the Editor
July 15, 2003
To the Editor:
In your recent article about New York's "demand curve" ("New York Throws a Curve," May 15), opponents dismiss the role of installed capacity in restructured electric markets. Instead, they suggest a complete reliance on revenues from the energy market to recover all fixed costs. Yet, as your article notes, an energy-only approach might require price spikes of up to $30,000/MWh to cover the fixed costs of "peaking" units that seldom run but are needed for reliability.
Experience has shown the danger of relying on huge price spikes during shortage conditions to finance the fixed costs of power plants. The "golden carrots" from shortage conditions are random and unpredictable. Customers cannot budget for them; investors cannot rely on them for financing. Worse, such a system is prone to market power abuse: Suppliers may be tempted to withhold just enough energy to create artificial scarcity to get the gold.
Moreover, when shortages lead to involuntary curtailments (e.g. blackouts), the impact on customers can be severe. New York suffered costly blackouts in 1965 and 1977, and responded by instituting requirements for installed capacity sufficient to minimize the likelihood of shortage conditions. The higher levels of reliability naturally lead to fewer hours of shortage prices and decrease the energy payments available to peaking units.
The ultimate solution is to develop the demand side of the market, so customers can respond to high energy prices by simply turning off the switch. With sufficient price-responsive load, there will be no need for involuntary curtailments. New York is working hard to develop price-responsive load, but it will take time for the demand side of this market to fully mature.
In the meantime, New York must place heavy reliance on peaking units to ensure reliability and must provide some means of covering their fixed costs. The capacity market was intended to provide a relatively stable revenue stream to cover these fixed costs. Unfortunately, the original design of the capacity market produced a "boom and bust" cycle that was almost as unpredictable as the energy market, and similarly subject to market power abuse. (For example, short-term upstate capacity prices ranged, almost randomly, between $0 and $9.58 per kW-month.) After lengthy analysis, we proposed a modification to the capacity market (the "demand curve") to remedy these problems so that the capacity market would operate as originally intended. The proposal was fully vetted, refined, and supported by the majority of NY-ISO (the New York Independent System Operator) market participants.
Contrary to opponents' claims, the demand curve does not guarantee a fixed price. Rather, the price is determined by the available supply of capacity. As the supply increases above minimum requirements, the price gradually declines. This ensures an appropriate long-term price signal in the capacity market and protects consumers from overpaying for excess capacity. At the other end of the demand curve, shortfalls lead only to gradual price increases, protecting consumers from sudden capacity price spikes and market power abuse.
Rational investment and maintenance decisions require a long-term view. Well-designed capacity markets can help inform these decisions by providing long-term price signals. Unfortunately, the original design of New York's capacity market produced erratic short-term spikes and crashes that tended to drown out the long-term signals. The demand curve should smooth these out, yielding more consistent, long-term price signals to guide investors and consumers.
FERC approved the NY-ISO filing on May 20, and the first auction under the demand curve took place on May 28. The spot auction price was $2.34 per kW-month, slightly above prior average auction prices but still well below the estimated cost of new capacity, due to the current excess supply in the Northeast. Under the demand curve, New York obtained over 2,000 MW of additional installed capacity above minimum requirements (largely through imports), which will add to New York's reliability and should improve the competitiveness of its daily energy markets. Given the current low prices for capacity in the Northeast, such additional purchases appear to be prudent.
So far, the demand curve appears to be working as intended to provide better price signals for long-term investment decisions. We will continue to carefully monitor NY-ISO's installed capacity and energy markets to make sure that electricity in New York is provided efficiently and reliably and is priced competitively.
Dr. Thomas Paynter
New York State Department of Public Service
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