Capacity Markets – Background

This post is part of a multi-part series on capacity markets.

Capacity Markets – Definition

Capacity Markets – Background

Capacity Markets – A look across the United States

Capacity Markets – Renewable Generation

In 2000 and 2001 the Western United States went through an energy crisis.  I was a student in a California public school at the time, and I remember getting to go outside and mess around because there was a rolling brownout during class.  The crisis cost Californians millions and led to the wacky recall of Governor Gray Davis though, for students at the time, it was awesome.

While most citizens blamed Enron and moved on, the Western U.S. Energy Crisis had a lasting impact on electricity market policies.  In its simplest form, the traditional electricity business model is to have one utility own all the power plants, transmission lines, and distribution lines and then sell power to end consumers.  Under this system, an electricity market is unnecessary.  The basic idea of electricity deregulation is that while transmission and distribution wires are a natural monopoly and should not be duplicated, electricity generation is not a natural monopoly.  Therefore, it makes sense to have one company (a utility) own the wires while other companies compete to make the cheapest power plants and sell power to the grid.  From this notion comes electricity markets.

In 1998, prior to the crisis, California transitioned to a system in which independent power producers (Dynergy, Mirant, Reliant, etc) sold electricity to distribution companies (PG&E, SCE, SDG&E, etc) on a day-ahead basis.  Pre-1998, the utilities owned both the power plants and the transmission and distribution.  The day-ahead power auction became coordinated through a central exchange, the California Power Exchange.  This system was generally described as “deregulation” or “partial deregulation” and was expected to reduce the cost of electricity to end consumers. 

California at the time was part of the Western Systems Coordinating Council (WSCC), now the Western Electricity Coordinating Council (WECC), which covers the Western Interconnection.  An interconnection represents a region in which all electric utilities are electrically tied together during normal system conditions and operate at a synchronized frequency (here is a map of interconnections in North America).

Electricity demand in the WSCC had been growing rapidly, led by growth in California and the southwestern United States.

Consumption by state, 1997-1998

Source:   Fisher, J. and Duane, T. "Trends in Electricity Consumption, Peak Demand, and Generating Capacity in California and the Western Grid, 1977-2000," Program on Workable Energy Regulation, University of California Energy Institute, Berkeley, CA, March 2002.

Meanwhile the region had faced years of low investment in electricity generating capacity.  Factors for low investment included the economic recession in the early 1990s which decreased demand as well as concern on the part of utilities that upcoming deregulation might limit their ability to recover the cost of building new facilities.

New utility capacity by state, 1977-1997

Source:   Fisher, J. and Duane, T. "Trends in Electricity Consumption, Peak Demand, and Generating Capacity in California and the Western Grid, 1977-2000," Program on Workable Energy Regulation, University of California Energy Institute, Berkeley, CA, March 2002.

Events came to a head in shortly after California partially deregulated the electricity sector in 1998.  In early 2000, wholesale electricity prices in the day-ahead market shot upward, reaching over 20x typical levels.  At the same time, the Pacific Northwest experienced its most significant drought in decades, causing a decrease in the hydroelectric power that could be exported from Washington and Oregon to California.

Water Discharge at the Dalles Dam, Columbia River

Source: Green Jouleus from U.S. Geological Service

This chart shows the water discharge at The Dalles Dam on the Columbia River, a measurement that serves as a bellwether for hydroelectric output in the Pacific Northwest.  It shows clearly that output spiked in April 2000 in parallel with spiking electricity prices in California.  However, due to the drought, hydroelectric output at this level was unsustainable and The Dalles had its lowest output in decades during the 2000-2001 period, the height of the Western Electricity Crisis.

One clear result of the Western Electricity Crisis has been a policy shift away electricity markets based largely on short-term sport market prices toward electricity markets which incorporate long-term capacity planning.  The WECC needed more electricity generation due to increased demand in the late 1990s, but utilities did not want to built generation out of fear of market deregulation.  Had regulators not intervened, the market would have corrected itself eventually.  High electricity prices of the crisis would have been a strong incentive for companies to build additional power plants and sell power at high rates.  Unfortunately, power plants take time to site and build, and in the meantime high prices caused large-scale blackouts across the state.

As a result of the Western Electricity Crisis, most restructured electricity markets throughout North America feature some type of market for capacity.  These markets facilitate payments to power producers in order to ensure that enough generating capacity will be available in future years to meet expected load.  Capacity markets represent central planning in that the free market does not decide how much generating capacity will get built–a regulator's load forecast does.  Regulators also demarcate the zones in which growth constraints are different (such as Manhattan Island vs. upstate New York), creating different prices for capacity within those zones.  Such a system makes sense given the time it takes to build power plants, and the costs of volatile prices to both consumers and power producers who are attempting to finance large investments.