As renewable electricity is added to the grid, are power markets misfiring?

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When increasing megawatt-hours of variable solar and wind energy began coursing through the grid, the initial concern was an operational one—could grid reliability be maintained. But it turns out those megawatt-hours are creating market challenges, as well.

What needs to be done to right the markets? Travis Kavulla, vice chairman of the Montana Public Service Commission, and Albert Cheung, head of analysis at Bloomberg New Energy Finance, have each taken a stab at answering that question in recent essays.

In “There is No Free Market for Energy: Can There Ever Be?,” Kavulla unpacks the entire history of utility markets and regulation. The essay ran in the 2017 summer edition of the conservative journal, American Affairs.

“The marketplace for electricity has evolved in the United States, but has done so in a haphazard way,” Kavulla wrote.

In his analysis, “Power Markets Need a Redesign – Here’s Why,” Cheung sets out to answer the question, “Is the rise of subsidized clean energy causing power markets to misfire?”

It is a question that needs answering for there is a clear and growing commitment to renewable energy by major utilities. Last November, Columbus, Ohio-based, American Electric Power Co. (AEP), which serves 5 million customers in 11 Midwest states, announced it will spend $1 billion on new solar facilities.

“This stuff is real, and it is happening,” Chuck Zebula, AEP executive vice president of energy supply, told analysts during the company’s third quarter earnings call. The investment is being financed in part by the sale of natural gas-fired and coal-fired plants.

And last month, Ben Fowke, CEO of Minneapolis-based Xcel Energy, which has 3.3 million electric customers in eight western and Midwestern states, told a wind industry conference, “We’re investing in wind because of the tremendous economic value it brings to our customers. Wind energy is saving our customers billions of dollars in fuel.”

Wind makes up about 20 percent of Xcel’s energy mix. “We have successfully integrated wind energy onto our system over the years without sacrificing reliability, and we’re making history in the process.”

While utilities are getting better at managing renewable megawatt-hours, and federal wind and solar tax credits along with state renewable energy standards have spurred development those megawatt-hours can roil the electricity market.

“These twin policies—the federal tax credit and the state renewable standards—have led to a glut of power sluicing around the sun-soaked Southwest and the windy Great Plains, and have had significant unintended consequences for the market in electric power,” Kavulla said.

For Kavulla, the renewables issue is a piece of a larger problem with financing and marketing electricity that goes back to the industry’s beginning, when at the outset of the 20th century, Samuel Insull promoted the concept of a regulated monopoly with a guaranteed return on investment.

“This so-called cost-of-service regulation suggests to the utility that it should spend as much as possible, even when less might do,” Kavulla said. “A utility earns a return even on the cost of decorating the C-suite.”

Still, the approach built an electrical system that powered American growth. “The system muddles through well enough,” Kavulla wrote. Though it has led to “significant deadweight” and deprives consumers of choice.

The advent of regional wholesale electricity markets, overseen by independent system operators or ISOs, was a step forward, but ironically, they have created yet another layer of byzantine regulation and bureaucracy.

“Paradoxically, competitive markets appear to attract more regulation. Consider the length of ‘tariffs,’ the written documents that control the prices or practices of a monopoly utility or a market operator like an ISO,” Kavulla said.

These markets have become even more complicated with the introduction of variable renewable generation, which can be abundant and low cost at times, and completely unavailable at others. While Kavulla and Cheung agreed there is a problem, they each have a different take on it.

The federal wind and solar production tax credit, Kavulla maintained, can turn market signals on their head, undermining the very essence of market competition.

Since the tax credit, about $23 a megawatt-hour, is based on the amount of electricity a facility produces, renewable energy generators have an incentive to produce power even when prices are negative, undermining other generation.

This has led to California natural gas plants operating at a loss during the day and then having to ramp up to capture the lucrative evening hours, Cheung said. Nuclear generation, which lacks the nimbleness of gas, is in a worse position, and that has led to more government intervention.

“The most recent and controversial examples are decisions by New York and Illinois to provide out-of-market payments to support their struggling nuclear plants, which have been undercut by gas and renewables,” according to Cheung.

“All of this is enough to make market purists wince: if we believe that wholesale power markets deliver the most efficient outcomes, they say, then why do we keep adding layers of additional incentives and mechanisms?” he asked.

Indeed, Kavulla argues that if such subsidized nuclear plants are allowed to compete in the so-called capacity market, it will become “distorted.” 

Neither Kavulla nor Cheung are fans of capacity markets, in which the ISO makes a calculation of how much generating capacity the system needs and then holds an auction for generating resources. Those that are selected get guaranteed payments.

“Unsurprisingly, ISO projections of consumer demand have often turned out, in retrospect, to be overestimates,” Kavulla said. The result is that utilities get to build more plants to put into their rate base.

Cheung agreed. “Capacity auctions administered by a central system operator are likely to over-procure due to risk aversion, and the high cost of getting it wrong and causing a blackout,” he wrote. “Because the capacity payments flow through to utility bills, it is the customer that pays over the odds if overbuild occurs.”

Utilities, however, are comfortable with the process as they are with other highly regulated aspects of the business—having devoted considerable resources to getting the most they can from the regulators, Kavulla said.

“The utility sector clamors for government’s involvement in its business decisions, and government is happy to oblige,” Kavulla wrote. “As a result, few products are regulated in such a command fashion as electricity in our supposedly free market society.”

The situation in the wholesale power market is more complicated. Kavulla sees it “warped” by subsidies, while Cheung notes that the market works on the short-term marginal cost to produce electricity and renewable sources are competitive.

The goal, Cheung said, is cheap, clean, reliable electricity, what he calls the “trilemma.” To answer the trilemma, he said, there are five issues that must be addressed.

  1. Maintaining credible incentive signals for long-term investments in energy and flexibility
  2. Optimizing short-term dispatch and balancing of supply, demand and storage
  3. Driving capacity build and energy provision in the geographical locations where it is most needed
  4. Unlocking the value of distributed resources, by exposing them to the markets and price incentives, and allowing distribution utilities to make optimal use of them
  5. Ensuring that markets are technology-agnostic, encourage innovation and are future-proofed for emerging technologies.

To achieve “clean,” Cheung said, requires a carbon price or emission targets. Kavulla agrees saying that a technology-neutral approach involving taxing, capping or trading emissions is the best option.

“If sufficient political support for such policies does not exist, the answer to this problem is simply to do nothing—or promote the development of as-yet-nonexistent tools to combat emissions through research,” Kavulla argued.

Kavulla is critical of states such as Colorado, Nevada and Minnesota where legislation and regulation, rather than market signals, have been used to phase out coal-fired plants. He called for the Trump administration to use the Federal Power Act to stop this trend.

To attain “reliable,” rather than using capacity markets, Cheung said, market price caps have to be removed, and the cost of a megawatt-hour has to be able to rise to thousands of dollars during periods of electricity scarcity to reward owners of rarely used backup capacity.

“For short-term flexibility, trading must be allowed to occur as near to real-time as possible, so that generators, storage providers and energy suppliers can respond to variable conditions even as weather forecasts are updated during the day,” Cheung said.

As far as making sure transmission and distribution investments are optimized, using zonal or nodal pricing is one step. A more radical solution would be to charge energy suppliers for the specific transmission links that they use when procuring energy from one location and supplying it in another.

For Kavulla, such tweaking of the market would have a very limited impact. “Nowhere, then, is there truly a free market in electricity,” he concluded. “Markets have competitive features, but they are so intermediated by command-and-control decision-making with respect to both supply and demand that they have more in common with old cost-of-service regulation than with a ‘willing-buyer, willing-seller’ market of the conventional imagining.

“Yet there is evidence that these sort-of-competitive markets still better serve customers than purely command-and-control regulation,” he conceded.

To that end, Kavulla calls for injecting competition in selecting new projects and the use of auctions, even if they are just sort-of-competitive.

“The best way to combat the perverse incentives of the utility industry, however, is by keeping up efforts to substitute monopolies with competitive firms,” Kavulla said.

Among the other reforms aimed at dealing with root problems in the utility model, Kavulla suggested putting regulated utilities on budgets tied to some objective metric, such as GDP growth or an index of inflation net of productivity, and making utilities more nimble by not requiring them to get utility commission approval for so many decisions. This would give utilities a freer hand with more responsibility, a chance of profit and risk.

“A day may come when something more genuinely competitive may be possible,” Kavulla said. “Regulators should always be on the watch for this and should be willing to put themselves out of a job if and when it occurs.”

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