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CERA: Resource Adequacy Biggest Challenge Facing Power Sector

October 24, 2005
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Resource adequacy is the most pressing issue facing the power industry today, a top official with Cambridge Energy Research Associates (CERA) said last Wednesday. There is a trend toward the issuance of request for proposals (RFP) to meet this challenge, but solicitations for capacity with long-term and short-term contracts are not necessarily silver bullets, CERA found.

Unless the resource adequacy issue is resolved in a timely fashion, "the country faces the potential of repeating a California-type energy crisis," CERA said in a sweeping new report, "Beyond the Crossroads: The Future Direction of Power Industry Restructuring." In most regions of the U.S., the power supply surplus will be disappearing between 2008 and 2012, the report said.

As part of its research for the report, CERA polled a group of various power industry participants and asked "is there confidence that the status quo of the power business today can deliver the needed power supply development in the future in the right amounts and the right time? And with a show of hands, it was pretty much unanimous with the group that we have assembled here [for the report], that there is no confidence that the status quo in the power business will get the job done -- of keeping resources for power supply adequate in the future," said Lawrence Makovich, managing director of CERA's Americas Gas and Power Group.

The report lists a total of nine possible mechanisms that could be used to ensure that future capacity needs are met. At the middle of the spectrum of mechanisms is the issuance of RFPs for capacity with short-term contracts and RFPs for capacity with long-term contracts.

"When you read the tea leaves of the current power landscape -- this mix of regulatory processes and market forces -- our conclusion is there's going to be an awful lot of reliance in the middle of this spectrum, on competitive solicitations, RFPs for new supply..., so a return of the purchased power agreement," Makovich said. He underscored the point that CERA is not advocating that this is the solution for the power industry when it comes to addressing resource adequacy.

"That is where we see a lot of resource adequacy trending right now, towards the middle solution in this spectrum that involves a lot of RFPs," Makovich said. One of the potential consequence of this, he said, could be price discrimination for capacity payments. "It's very likely that new capacity under these solicitations gets paid what it takes to get them built, and old capacity will get paid less, but enough to keep them running, and that could be a defining characteristic in a lot of these power markets."

Addressing RFPs for capacity with long-term contracts, the report said that in states or regions where traditional regulation of vertically integrated utilities has not been altered, the introduction on RFPs could provide advantages in the resource adequacy process by bringing competitive forces to bear on future capacity prices and providing other efficiency gains.

However, in regions with developed capacity markets, the use of long-term RFPs "can seriously undermine the markets' viability both by depressing market prices and by creating an uneven playing field."

CERA said that using long-term RFPs to build new capacity simultaneously with the operation of a capacity market could create a series of unintended and costly outcomes. "If RFPs are relied on simultaneously with the use of capacity markets, it is important to recognize that the RFPs may inhibit the establishment of a workable capacity market that companies have confidence in, produce costly use of RMRs [reliability must run agreements], discourage beneficial upgrades to existing power plants, and potentially place those utilities committed to buying the capacity from the RFP in an untenable position."

The report said that long-term RFP use may be warranted to remedy special circumstances, for example, the difficulty of siting generation in New York City. "However, the policy of using long-term RFPs simultaneously with existing capacity markets should be extremely limited and preferably phased out."

As for RFPs for capacity with short-term contracts, CERA said that "because of their recent implementation, they are untested as a mechanism for financing investment in new generation. These short-term contracts were never intended to solve long-term capacity needs."

Short-term RFPs to meet resource adequacy needs "are more a mechanism for keeping capacity available than for supporting the construction of new generation, unless there is stability in the regulatory rules that will allow wholesale suppliers/generators sufficient comfort about financing new plants."

CERA said that resource adequacy rules have to be established by an entity taking full responsibility for their implementation, preferably at a regional level. "These rules should be set at least five years ahead of reaching the supply-demand balance point," the report said. "While there is still a window of opportunity to implement new resource adequacy mechanisms in many regions, rules should be settled upon as soon as possible to avoid any capacity shortages in the future."

Along with raising alarm bells over resource adequacy, the report said that residential electric customers in the U.S. paid about $34 billion less for the power they consumed over the past seven years than they would have paid if traditional regulation had continued.

"Although the conventional wisdom says that deregulation has failed to lower power prices, real power prices are lower -- compared with the previous regulated period and with what prices would have been if traditional regulation had continued," CERA said.

The gap between perception and reality "suggests that power price trends are misunderstood. It may be that industry observers are confusing nominal price changes with real price changes, or that people have generalized the well publicized California power shortage and the associated western U.S. price spikes as the typical deregulation outcome. In some cases, industry observers assume that only large commercial and industrial customers have achieved any savings from deregulation because these are the customers who have actually shopped around and switched power suppliers in significant numbers."

The residential savings identified in the CERA report are in addition to any savings found in the commercial or industrial customer segment. "These are net savings, reflecting the gains from introducing more competitive pressures into the power business -- greater efficiency, more innovation, and cost discipline -- along with the effects of mandated price freezes, the costs of flawed market designs, and the losses of competitive power investors."

According to the report, a significant portion of the gains are due to power customers' not shouldering the cost of much of the capacity added in the post-1997 period. Instead of the costs of new supply going into ratebase and thus regulated prices, deregulation shifted the costs to investors who held the market risk.

The cumulative estimated savings in non-western regions over the deregulation period in real 1997 dollars is $42 billion. Although the South has the largest savings in absolute terms ($24 billion), it works out to about $5.20 per MWh. The highest per-unit savings is in the Northeast, where spreading $8.5 billion savings over sales yields a $7.30 per MWh difference. The Midwest is the smallest in both absolute and per unit terms -- $9 billion and $4.20 per MWh.

In the West, on net, had regulation continued, residential power customers would have experienced the shortage but spent $7.3 billion less on electricity than they did with a shortage and deregulation.

"One implication is clear -- deregulation reallocated risk in the power business," CERA said. "The risks associated with a shortage fell on consumers (the outcome in the western region), whereas the risks associated with a surplus (the outcomes in the other regions) fell on investors."

CERA said that from an economic perspective, these savings and the associated price changes from the historical regulated levels "are not appropriate criterion by which to measure the economic success or failure of deregulation. Instead, deregulation and markets should be judged by a wider set of criteria -- including how well power prices line up with production costs and provide the proper economic signals."

Meanwhile, CERA's current analyses shows that the rapid increases in fossil fuel prices over the past year mean real power prices will increase in the near term -- whether power prices are regulated or deregulated. Real power price increases in the years ahead shouldn't be misinterpreted as a failure of deregulation, Makovich said.

"If we've got a fundamental increase in the inputs to power production, whether prices are regulated or deregulated, they're going to have to go up as a result," Makovich told reporters. "And if we've misunderstood price changes and deregulation in the past, there's a real danger going forward that the substantial price increases we're going to see across the next year are going to be misunderstood as a failure of deregulation and it just is not the case."

Makovich said that "We're expecting that in many places, we'll see double digit increases in the price of electricity" for 2005-2006, "particularly for those areas that don't have good, balanced portfolios and have very heavy reliance on the fuels that have gone up the most."

The report grades U.S. power deregulation and finds that "After nearly a decade of restructuring, progress in moving to competitive electricity markets is mediocre at best. Although workable markets are developing in some regions, and in some cases are performing well, power industry restructuring across North America overall earns an aggregate grade of C+."

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