Filling the Hole in California’s Capacity Procurement Plan

In February, the California Public Utilities Commission (CPUC) yet again missed an important opportunity to correct structural flaws that have plagued the state’s wholesale generation market in the wake of the 2001 energy crisis. The CPUC authorized the procurement of as much as 2,100 MW of new resources, without taking steps to ensure that market structures are in place to appropriately value and compensate existing generation resources. Absent fixing current long-term procurement planning and resource adequacy policies, California risks stranding existing resources, while saddling consumers with more costly long-term commitments for new resources that may be subsequently rendered less valuable by changed circumstances.

A “Hole in the Market”

Generation capacity in California has traditionally been assessed generically, without regard to specific operational flexibility or attributes. Capacity procurement has been analyzed from the perspectives of planning reserve margins and resource adequacy. These objectives were understandable responses in the aftermath of California’s energy crisis when “steel in the ground” was of paramount importance. However, more than 10 years later, these criteria are ill equipped to address fundamental changes resulting from the influx of large amounts of intermittent renewable resources.

Today, grid operators should be leveraging the existing gas-fired generation fleet to help integrate renewables. However, the market structure necessary to encourage investment in maintenance activities and operational improvements does not exist. On the contrary, compensation available from the limited markets currently available to noncommitted existing resources, such as the market for energy, has been declining. Prices for such energy are expected to drop further as regulators approve the procurement of new resources and more renewable resources come online to meet renewable procurement goals.

The adverse impacts from declining market revenues are further exacerbated by the fact that existing generation resources are excluded from participating in long-term resource solicitations under the CPUC’s current procurement policies. The Brattle Group recently found that the compensation available to new resources in California resource solicitations exceeds the compensation available to existing resources by multiples of “five to ten.” This combination makes revenue streams available to existing resources both insufficient and unpredictable on a year-to-year basis. These market and price uncertainties discourage investment in efficiency and flexibility upgrades that could more cost-effectively increase the amount of capacity with enhanced flexibility attributes available to grid operators.

CPUC Commissioner Mark Ferron describes the phenomena as a “hole” in the market: “There are insufficient economic incentives for [existing] generating plants which provide useful flexible attributes to cover the cost of maintaining these plant[s] in operation.” Under these circumstances, the disparate treatment of new and existing generating resources leads to inefficient procurement and undermines least-cost/best-fit procurement objectives.

Use Multiyear Forward Procurement

Procurement policies that unnecessarily differentiate between new and existing resources must be changed to incorporate nondiscriminatory practices that advance competition across resource type. Competition between new and existing resources will provide more revenue certainty and better identify the ability of the existing fleet to cost-effectively meet integration requirements relative to new resources. For example, the most economically efficient solution to provide for an incremental system need may be a relatively inexpensive upgrade to an existing generating resource, as opposed to the major investment required for a new resource. However, markets must be open to competition to allow for the most economically efficient (whether it be an existing or new) resource to be selected. This competition can occur several ways, such as through a centralized forward capacity market, but it must include an explicit multiyear forward procurement requirement.

In general, a multiyear forward procurement requirement should better ensure the retention of cost-effective existing resources to satisfy future reliability requirements. For instance, a centralized forward capacity market levels the competitive playing field among all suppliers. In such a market, suppliers bid to provide exactly the same product over a defined time period. As a result, the risks buyers typically bear because of the difficulty in accurately comparing the value of offers of different terms (for example, a three-year versus a 10-year term) are substantially reduced.

A centralized forward capacity market would also increase procurement efficiency, particularly as system needs become more defined and differentiated by specific operating characteristics. Procuring a portfolio of capacity that meets defined flexibility requirements for the whole system should be less costly than having each individual load-serving entity procure a portfolio of capacity that meets its share of system flexibility requirements.

Address Procurement Comprehensively

When compensation from the markets is insufficient and/or uncertain to ensure recovery of going-forward costs—including investments in operational improvements—procurement efficiency decreases, commodity cost increases, and reliability is put at risk. In other words, everyone loses.

Forward capacity markets are not novel concepts. They are standard practice in major eastern U.S. power markets, such as PJM. The CPUC itself has acknowledged that a forward procurement obligation is a regulatory tool that could potentially benefit reliability and reduce costs. To date, however, the CPUC has failed to adopt such a requirement. Instead, it has continued to authorize the procurement of new resources without accounting for the broader market implications. California can no longer afford this one-dimensional (new is good) planning, and the CPUC must start addressing procurement on a more comprehensive basis.

Jeffrey P. Gray (jeffgray@dwt.com) is a partner and Vidhya Prabhakaran (vidhyaprabhakaran@dwt.com) is an associate in Davis Wright Tremaine’s Energy Practice Group.