Soaring Capacity Prices and Changing Economics of Electric Reliability

The Power Line is a newsletter series that reviews key stories in the electric power sector—ranging from grid reliability, transmission issues, and emergent technology and business models. The Power Line will highlight the connections and relevance between the sector’s technical, local, and often esoteric stories to high-level public policy conversations on climate and energy taking place in Washington, D.C.

Shock and awe have emanated across the U.S. electric power sector since the PJM capacity market, which covers all or part of 13 mid-Atlantic and Midwest states, delivered sky-high pricing results. For most zones in the market, capacity prices rose nearly tenfold from the previous auction. In the Virginia zone, the data center capital of the world, prices cleared even higher.

With a total cost to load of $14 billion, these results will further propel a broader debate over the direction of electricity rates amid a historic upturn in electric demand growth, the need to build new transmission capacity, and the overall direction of reliability in the U.S. electric power sector.

To be sure, much of the story is unique to PJM market design factors. But at the level of national policy and the broader global energy transition, there is a lesson here about the changing economics of electricity and the easily underestimated complexity, cost, and uncertainty associated with transformation in the electric power sector.

How PJM Procures Capacity

The ordering objective of all electric power systems is to ensure sufficient supply to meet demand on a finely tuned, minute-by-minute basis. Failure to do so brings severe short-term consequences—see, for example, the costs of system failure in Texas during Winter Storm Uri; persistent failure creates devastating macroeconomic effects—see, for example, the consequences of structural shortages in South Africa.

In PJM, this balancing mandate is achieved with carefully designed market constructs. Electricity consumers in PJM pay for the actual production of electricity by generation resources on a day-to-day basis according to prices set by short-term markets for energy. However, ensuring that this daily market always, across all conceivable weather scenarios, has sufficient supply resources requires some forward planning function. PJM achieves this with an annual market for capacity, in which electricity consumers effectively pay for three-year-ahead commitments from generation to be available during peak demand periods.

This year’s surge in capacity prices reflects a mix of supply and demand factors. On the supply side is the ongoing and steady trend of retiring fossil fuel–fired plants, primarily aging coal-fired plants burdened by decreasing utilization rates and increasing regulatory compliance costs. On the demand side is, of course, the accelerating rate of demand growth.

Most important, however, were market reforms undertaken in the wake of Winter Storm Elliot, in which PJM adjusted the capacity ratings of generation resources to reflect their realistic performance in winter storm scenarios. Gas-fired combined-cycle plants saw their capacity rating fall from nearly 100 percent to 79 percent to reflect the real risk of plant outages or the inability to access fuel via pipelines. Given the overall size of the gas-fired fleet, these derates decreased the overall supply of capacity considerably.

Local Implications

The obvious impact is increased rates for consumers, though the exact effect on any given bill is filtered depending on who the supplier is and how that supply is contracted. On the other hand, these results are the market signal at work. Sky-high prices reflect the underlying trends that PJM itself has warned about toward reduced generation reserve margins and reliability. One should expect these prices to induce investment into new capacity resources, delay some retirements, and drive increased participation by demand-side resources such as virtual power plants. Prices should clear lower in the coming years, and new resources will improve reserve margins and reliability.

Setting aside the specific market design and outcomes in PJM, similar basic trends are at work to varying degrees across the United States; demand growth, the retirement of dispatchable generation, and backlogged queues delaying the new resource interconnection create worrisome reliability trends.

Changing Economics

For electricity systems across the world, whether organized as markets or as integrated utilities, the changing composition of generation resources makes the need for markets, tariffs, or other regulatory constructs that channel funds to resources providing reliability services distinct from energy ever more crucial. In California, there are rapidly escalating rates for the state-administered Resource Adequacy construct. The Power Line has covered similar developments in China, Germany, and Texas.

The root cause of all these sectoral changes is the changing economics of electric reliability. Renewable resources provide very low-cost energy to the system, but their variable output profile provides limited capacity (see the low-capacity ratings assigned by PJM). Meanwhile, the generation that can provide capacity services operates at ever-lower utilization rates as they are displaced by near-zero marginal cost renewables, resulting in reduced revenues and potentially unviable financial positions. Nonetheless, some portions of these capacity resources are crucial for overall reliability, and so new mechanisms or higher prices must result to retain their availability.

Key Takeaways

This dynamic is not a verdict against renewables; it is entirely possible that lower whole-of-system costs can be achieved within these changing dynamics. The falling cost and increasing deployment of battery storage resources that provide capacity services is one reason to be optimistic about this possibility.

Instead, the lesson lies in the complexity of sectoral transformation. Yes, there are technical engineering challenges associated with intermittency, optimizing battery dispatch, inertial stability, and more. But electric grids are more than just technical systems. They are finely balanced financial constructs, carefully calculating and allocating costs required to perpetuate a multifaceted public good. The institutional development of electricity systems, deeply wrapped up in the political economies of the states they serve, is no small feat. The surging capacity prices in PJM are one small reminder of the highly complex task of rapidly transforming both the engineering and the economics of such an institution and indicate that such transformation will likely be slower and bumpier than commonly assumed.

Cy McGeady is a fellow with the Energy Security and Climate Change Program at the Center for Strategic and International Studies in Washington, D.C.