01/07/2020 - Legal Analysis

FERC’s Clean Energy Boycott Distorts PJM Prices and Discards History

by Ari Peskoe

This article appeared in UtilityDive on January 7, 2019.

FERC’s recent decision setting new rules for PJM’s capacity auction will exclude clean energy resources from PJM’s procurement and force PJM to buy more capacity than it needs to keep the lights on. While claiming to act in defense of market integrity, FERC overrides consumer and policy preferences for clean energy and rigs PJM’s auction process to benefit a particular class of investors. FERC’s decision abandons the tenets of its long-standing efforts to facilitate competitive power markets and disregards billions of dollars of added costs it imposes on consumers.

How We Got Here: Competition Achieves Policy Goals

In the 1990s, FERC took bold action to foster the development of competitive power markets. Power generation was then completely dominated by monopolist utilities that restrained competition by operating their transmission systems for their own benefit, effectively blocking potential rivals from trading power. FERC had long refrained from upsetting utility dominance, believing that encouraging coordination among utilities was the best means for improving the industry’s efficiency. Industry developments, including boondoggle utility generation projects and federal regulatory changes, led FERC to question its own core belief.

FERC recognized it needed a new approach and opened the closed utility system to new investment to achieve results, such as transferring risks of expensive failure from ratepayers to investors, spurring business model innovation, improving operational efficiencies, and allowing for more rapid adoption of new technologies. These widely shared goals and the deterioration of the utility-dominated model spurred FERC to act. Its policy shift from promoting utility coordination to facilitating open competition was feasible only because the industry was already heading in that direction.

FERC’s key move was requiring all utilities to end unduly discriminatory business practices and provide fair transmission service to all. With this open-access transmission mandate, FERC unlocked the utility-owned delivery system, enabling new entrants to sell power. Fair competition, according to FERC, required that it address market power. FERC also broke apart utility clubs called power pools that regionalized anti-competitive practices and encouraged utilities to replace them with independent system operators (ISOs) that would manage the transmission network without utility interference.

PJM was one of the first ISOs, and a pioneer in administering competitive power markets. Its energy market design responded to FERC’s mandate that transmission operators price transmission service transparently and fairly. Under PJM’s innovative locational marginal pricing (LMP) scheme, energy prices vary across the region based on transmission availability. High prices in a particular area signal that additional transmission to bring in low-cost power or new generation may be both profitable to investors and beneficial to consumers by lowering energy prices.

By the mid-2000s, PJM found that investment was uneven across the region and warned FERC of potential reliability issues. Industry stakeholders agreed to propose an annual capacity auction that would motivate investment by providing developers with additional revenue. Borrowing from the energy market design, the proposed capacity auction would generate locational prices in order to stimulate investment where it was most needed to keep the lights on.

FERC approved the auction, emphasizing the connection between PJM’s capacity procurement and its obligation to maintain reliability. The rules instructed PJM to purchase the lowest cost mix of resources capable of meeting reliability targets. Within each regional zone, PJM pays resources the same price. High prices signal potential reliability problems in that zone and motivate developers to invest in new projects, thus addressing the capacity scarcity and lowering capacity prices for consumers.

What’s New: Competition – Redefined – Raises Costs and Opposes Industry Trends

FERC’s December 2019 order radically changing the PJM capacity auction rules disconnects prices from reliability. The new rules are designed to prevent PJM from buying capacity from certain resources that earn revenue outside of PJM markets. As a result, PJM will decline to purchase capacity from nuclear plants, offshore wind farms, and other resources even though they undeniably contribute to regional reliability. Under the new rules, a high capacity price in a particular zone may indicate an abundance of resources that PJM must boycott rather than a potential reliability problem.

FERC defends its boycott by arguing that it’s restoring “competitive” prices. It’s unfair, according to FERC, that merchant developers that earn nearly all of their revenue from PJM markets must compete in the auction against developers that sell renewable energy credits (RECs) and utilities that finance capacity through retail rates. These out-of-market revenues or regulatory financing mechanisms enable non-merchant developers to offer their capacity at lower prices than merchant generators, thus “suppressing” prices produced by the auction and denying merchant developers revenue they should have earned from higher “competitive” prices. FERC concludes that mitigating market power is insufficient for facilitating competition, and that its allegiance to “free markets” requires it to conform market rules to its preferred business models.

Excluding non-merchant developers from the auction will inflate prices without providing benefits to consumers. Artificially high prices, distorted by FERC’s decision to divorce them from reliability, may compound an existing capacity glut by motivating new merchant investment that will further distance the auction from PJM’s needs. FERC claims that it’s merely “leveling the playing field” by excluding non-merchant resources from the auction, but it neglects the purpose of the game. Competition through the capacity auction ought to procure the least-cost mix of resources that meet reliability needs. FERC discards that fundamental premise in favor of creating a walled garden that distorts prices to benefit merchant developers and then sweetens the deal for this favored class of investors by ordering PJM to purchase more capacity than it needs.

While merchant developers (primarily private equity investors) will be the main beneficiaries of PJM’s over-procurement, clean energy buyers will be the biggest losers. Most PJM states require utilities to meet renewable energy targets or support specific clean energy resources, such as nuclear plants or yet-to-be-constructed offshore wind farms. Some of these programs may become more expensive, as clean energy resources unable to earn PJM capacity revenue turn to ratepayers for additional support. Meanwhile, ratepayers will also pay for PJM’s increasingly expensive over-procurement through the capacity auction. Corporations, cities, utilities, and individuals that choose to buy clean energy will also pay more. FERC erects barriers to entry for all new resources that sell RECs.

FERC recognizes that policy mandates and consumer preferences will bring more renewables to PJM. Yet, FERC forces PJM in the opposite direction, fighting against one of the industry’s dominant trends. FERC’s decision will result in consumers paying more for resources that they don’t want. And FERC’s order hardly provides a “level playing field.” Even if renewable developers forgo REC sales or overcome various administrative hurdles to qualify for the auction, the auction design is inherently “ill suited” to finance renewables. As FERC’s chief economist has explained in an academic paper, PJM’s capacity auction design is implicitly biased against renewable resources.

A better path forward would have been for FERC to accommodate industry trends. In June 2018, FERC suggested such a path, requesting that PJM propose auction designs that reduce the amount of capacity it would procure for each clean energy resource it excludes. Under those proposals, PJM would recognize the reliability contributions of clean energy resources and buy from the auction only the additional quantity it needs to keep the lights on. Such an auction design would have respected policy and consumer preferences. FERC’s December decision rejects those proposals without explanation.

In fighting against the power industry’s future, FERC loses the connection to its own past. Rather than following industry trends, as it did in the 1990s, FERC prioritizes superficial fidelity to free-market ideology. Its pro-competition agenda has historically sought to facilitate new entry by pushing back against incumbents and ensuring that market rules are fair to all resources by properly valuing their reliability contributions. FERC’s decision discards these core tenets. It rewards a favored class of investors by doubling down on a financing mechanism that ignores consumer preferences, and it disconnects that mechanism from reliability while demanding that it subsidize incumbent resources. FERC’s pro-competition rhetoric in its decision masks real-world consequences. PJM will buy less clean capacity, and clean energy will become more expensive for everyone in the PJM region.