Restricting bids for new capacity raises costs, lowers reliability

Most sponsors of bid solicitations seek to attract the maximum number of high-quality bids. Basic economic principles tell us that the greater the number of respondents to a solicitation, the greater the competition and the greater the benefits to the solicitor.

Somewhat counterintuitively, and notwithstanding California’s need for more electricity supply, the state’s utilities are the latest (but undoubtedly not the last) to bar existing power plants and some plants under construction from submitting bids to satisfy long-term requests for procurement of generating capacity.
 

Short-sighted strategy

The utilities justify this exclusion on the basis that their long-term requests for offers (RFOs) are seeking incremental generating capacity, and that awarding a contract to an existing power plant does not lead to any new construction.

From short-term and exercise-of-market-power perspectives, this justification offers superficial appeal. An existing power plant does not need a contract to obtain construction financing. Furthermore, fully appreciative of their monopsony buying power, utilities are aware that an existing power plant has no meaningful alternative market for long-term sales contracts other than the incumbent utility. Thus, deprived of a long-term contract, the existing generator can only, absent shutting down altogether, sell its energy in spot markets, in effect allowing the control area, and the utility, to use its capacity at no cost.

These justifications ignore the longer-term negative effects of excluding existing power plants from utility procurement RFOs. The approval by regulators of these exclusionary and monopolistic practices, rather than encouraging the development of new generation, increases procurement costs, retards development of new generation, and hampers system reliability.
 

Less liquidity, higher prices

The exclusion of existing power plants increases RFO procurement costs in several ways. A constructed plant should be expected to submit an extremely competitive price. Its capital costs are known, based on construction costs incurred in presumably lower-cost prior years. The generating facility also need not factor in "contingency premiums" for permitting or construction risks. Furthermore, an operating power plant offers the utility greater value by removing any risk of construction delays or failures and the need for contingency planning.

The exclusion of existing power plants will also cause the prices bid by new projects to increase for several reasons. The prices offered by a new generator will inevitably reflect the confidence that its bid will not have to compete with bids from lower-cost existing generators. Moreover, the new generator must set its bid at a level that will enable it to recover all its costs and earn any profits based on its first contract. By definition, at the expiration of the first contract, the eligible "new generation" bidder of today will evolve into an "existing project" and thus be excluded from later solicitations.
 

Triple threat

Barring existing plants from participating in utility RFOs also undermines, in three ways, efforts to improve system reliability and efficiency and decrease environmental emissions. Existing power plants that desire to participate in utility RFOs tend to have been constructed during the recent era of "merchant generators" and thus most often operate more efficiently and cleanly than older plants. Depriving these newer plants of any opportunity for a firm contract will reduce their operating hours and conversely enable older, higher-heat-rate, more-polluting units to continue to operate at high capacity factors.

Second, the exclusion will reduce the amount of new generation, contrary to the utilities’ "strategy" to encourage incremental generation capacity. Project sponsors and financial backers will hesitate to engage in meaningful project development activity, knowing that at most they have one RFO for which to submit a bid and one contract with which to realize all necessary revenues.

Third, the "build and be excluded from RFO eligibility" discipline runs counter to the objectives of state permitting agencies to process applications to construct power plants in a timely fashion. A fully permitted plant prejudices its ability to market power by proceeding with construction. This anomaly is a primary reason why an unprecedented number of permitted projects remain on the shelf, despite America’s increasing need for more, more-efficient, and cleaner power plants. Our energy policies should be designed to encourage permitted projects to proceed immediately to construction and operation.
 

Level the playing field

Sanctioning utilities’ exclusion of existing power plants from long-term power procurement RFOs is counterproductive, particularly for states facing generation shortages and seeking cleaner energy. The new, more-efficient, less-polluting generation that all constituencies are demanding will best be achieved if procurement programs allow plants to compete on their merits, rather than implementing exclusionary practices and dubious economic theories.

Steven F. Greenwald leads Davis Wright Tremaine’s Energy Practice Group. He can be reached at 415-276-6528 or stevegreenwald@dwt.com. Christopher A. Hilen is Of Counsel to the Energy Practice Group of the national law firm Davis Wright Tremaine LLP. He can be reached at 415-276-6573 or chrishilen@dwt.com.