Policy Studies

Enhancing market signals for electric resource adequacy

Reliable electric service has major benefits for society. But there are also costs, as reliability depends upon having sufficient aggregate supply to meet demand, or generation “resource adequacy,” as well as transmission and distribution reliability. Regulators have a long history of employing standards for electric reliability but with little consideration for the economic costs and benefits. However, mounting evidence shows that incentives are far better tools to lower costs, benefit consumers and drive innovation. On top of this, new technologies are rapidly altering the economic characteristics of resource adequacy, with major policy implications.

Historically, resource adequacy was non-excludable, which meant that suppliers could not limit receipt of their product to those parties that pay for it. This creates an incentive for market participants to “free ride” on this “common good,” which results in under-provision of the service by private actors. This formed the policy basis for treating resource adequacy as a pooled resource, where participants share equally in resource adequacy benefits and costs, by enacting compulsory resource adequacy mechanisms to ensure sufficient resource procurement.

However, resource adequacy policy differs markedly between states that retain monopoly regulation and those that adopted competitive electricity markets.  Regulated states require monopoly utilities to procure resources on behalf of customers, typically through a cost-minimizing process known as integrated resource planning (IRP). This feeds into the process for regulators to decide whether to approve utility investment in new resources for which they earn a guaranteed rate of return. In deregulated or “restructured” states, load-serving entities (LSEs) buy power on the wholesale transmission market and resell it to end-use consumers, who have the option to choose their power supplier. Competitive “merchant” resource owners decide to retire existing resources or build new ones based on expected returns from net revenues in the wholesale market.

All competitive wholesale markets operated by regional transmission organizations or independent system operators (RTO/ISOs) employ energy and ancillary service markets. These short-term markets reflect the marginal cost of system operations at granular locational levels and short time intervals. They provide incentives for long-term resource investment (retirement or new entry) by providing a basis for for-ward price expectations. To ensure resource adequacy, RTO/ISOs employ shortage or scarcity pricing that administratively sets prices above marginal cost when resource reserves run short. This “energy-only” paradigm provides additional revenues to influence investment decisions in most of Texas, for example. In other restructured states, RTO/ISOs use capacity markets to supplement energy markets by administratively defining the capability needs of the system and the value of various resources to provide this capability.

New technologies are rapidly changing the abilities of unconventional resources to provide resource adequacy, and even changing the economic designation of resource adequacy as a “common good.” In particular, the proliferation of “smart grid” technologies enables the ability to isolate con-sequences of resource shortfalls to parties responsible for those shortfalls. In other words, the ability to “privatize the commons” is emerging, with significant economic ramifications. The concurrent rise of dynamic production profiles of variable- and use-limited resources – especially wind, solar and energy storage – align far better with the dynamic capabilities of market paradigms for resource adequacy.

Given the advent of unconventional resources and “smart grid” technologies, this paper has several findings with implications for resource adequacy policy:

  1. Low marginal costs place greater emphasis on resource adequacy constructs. In a market context, a greater proportion of suppliers’ net revenues will come from shortage or capacity payments. This amplifies inefficiencies associated with design flaws in capacity markets and price formation flaws in energy markets.
  2. The economic advantage of market-based resource adequacy mechanisms grows. With conventional resources, a well-designed energy market should economically outperform a capacity market, followed distantly by IRP. These gaps widen with emergent, unconventional technologies.
  3. The economic advantage of market incentives over uniform standards grows. “One-size-fits-all” resource adequacy is outdated and inefficient. Well-functioning markets reflect what customers are willing to pay for reliability and enable customers to express this willingness through dynamic participation in electricity markets. This requires revising some reliability standards that constrain the ability to enhance reliability incentives and differentiate reliability products.
  4. The North American Electric Reliability Corporation (NERC) is best suited as a technical resource on market design issues, rather than as an economic policy advisor. Technical input from NERC should feed into resource adequacy policy (e.g., evaluating new technologies and reporting on reliability metrics), but NERC’s perspective will not robustly account for economic efficiency. This is because NERC-led resource adequacy policy will be standards-heavy and, in many cases, inconsistent with market principles. Accordingly, reliability organizations such as NERC should consider the effects of new technologies on reliability standards in a manner that accommodates economically efficient curtailments of service.
  5. Potential shortfalls of essential reliability services (ERSs) may justify dedicated market procurement mechanisms. Market mechanisms will acquire a more efficient level of ERSs at lower cost and with better innovation incentives than a standards-driven approach. Of all market options, to pay for delivered service should lower costs compared to procuring differentiated, specialized forms of capacity.
  6. Evolving technology plays to the strengths of energy-only markets but, at the same time, exposes their vulnerability to any price formation deficiencies. The dynamics of unconventional resources and the ability to privatize resource adequacy are ideally suited for the energy-only paradigm.
  7. Efficient energy price formation is critical for energy-only markets and beneficial for areas with capacity markets. Capacity mechanisms should supplement, rather than substitute for measures to improve energy price formation. To this end, the R Street Institute has laid out a series of current price formation priori-ties for the Federal Energy Regulatory Commission and Texas regulators to consider.
  8. For regions committed to capacity planning, the advantage of using markets grows with the advent of emerging technologies. Capacity markets have far greater potential than IRP to capture the temporal and spatial dimensions of resource adequacy and to provide superior incentives. Capacity planning must become more sophisticated to value diverse resources accurately, and should also consider flexibility provisions to enable broader adoption of differentiated reliability.

Put simply, resource adequacy policy should adjust to reflect the evolving state of technology. The most valuable lesson is the growing advantage of market paradigms over monopoly utility IRP. Generally, the value of incentives over standards grows with a more diverse, dynamic suite of technologies that policymakers should leverage to empower consumer choice and unleash competitive forces.

Image by Makhnach_S


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