Monday Study – A Plan To Boost Renewables-Rich Power Systems’ Reliability

Resource Adequacy in a Decarbonized Future Wholesale Market Design Options and Considerations

Sylwia Bialek, Justin Gundlach, Christine Pries, March 2021 (Institute for Policy Integrity)

Executive Summary

Electricity supply must match electricity demand at each instant to prevent outages. Thus, the reliability of electricity supply depends on there being both an adequate set of generation resources to meet the highest level of demand and a system capable of delivering power from those resources to end-users. This report focuses on the first of those two components: the sufficiency of generation capacity, termed “resource adequacy.” Different jurisdictions employ different approaches to resource adequacy.

This report focuses on those jurisdictions that use wholesale market mechanisms to incentivize sufficient generation capacity. Broadly, the approaches taken in those jurisdictions can be divided into two types: energy-only, in which revenues from payments for electric energy must cover the costs of investing in generation as well as operating it; and what we call energy-plus-capacity payments, in which a price cap in the energy market limits prices that could be paid for energy, leaving a deficit that is filled in by payments for capacity. In all jurisdictions, those mechanisms were designed to support investments in conventional, thermal generation resources, most of them reliant on fossil fuels. Consequently, the growing presence of renewables on the grid has raised concerns about whether existing approaches to resource adequacy—energy-only and energyplus-capacity payments alike—can continue to serve the changing electricity sector efficiently.

Similar but differently motivated concerns arise from evidence suggesting that existing approaches to resource adequacy embody biases that favor fossil-fueled generation and tilt the field against renewables. This report examines these concerns by looking to the relevant economics and policy literature, and to the empirical evidence gathered by regulators and researchers. It finds that both types of approach are flexible enough to be compatible with scenarios in which renewables are pervasive. Indeed, in principle, each approach can arrive at the same outcome. But this report also finds that a region’s approach to resource adequacy can bear on the pace of renewables’ deployment, and that relying on capacity payments creates more opportunities to favor thermal resources and impede renewables. Recognizing that the political challenges of adopting and maintaining an energy-only approach to resource adequacy make capacity payments a likely feature of most regions’ approach, this report takes a close look at how capacity payments can favor some resources over others and suggests steps to avoid or at least mitigate such discrimination. Those steps, which include improving energy price formation, increasing demand responsiveness, expanding the availability of hedging instruments, refining capacity demand curves and available capacity products, and updating non-performance penalties can make energy-and-capacity market designs friendlier for renewables. Notably, several of the suggested improvements would be applicable in energy-only settings as well as those where energy-plus-capacity payments operate. Individually and in combination, those incremental changes would make markets more capable of efficiently facilitating the transition to renewable resources.

click to enlarge

Introduction

If electricity supply does not match demand at each instant, a widespread blackout can occur. Having, at each instant, sufficient generation capacity ready to match electricity supply to demand is called “resource adequacy.”1 It is distinct from reliability, which additionally concerns the ability to deliver power over a stable electric grid in spite of disturbances. This report considers the relationship between resource adequacy and renewable energy. More specifically, it examines whether current approaches to resource adequacy are capable of ensuring that the lights stay on in high-renewables deployment scenarios, and considers how different approaches to resource adequacy can affect the pace and pattern of renewables’ deployment. Based on this examination, it concludes that, while certain adjustments are necessary, current approaches to resource adequacy are indeed compatible with maintaining system reliability and operating a renewables-heavy grid. It then provides recommendations for market design measures that can support the cost-effective provision of resource adequacy amid continued deployment and integration of renewables into the grid. The feasibility of an approach to resource adequacy depends most fundamentally on whether the dispatch of electricity in a given region is coordinated through centralized wholesale energy markets or vertically integrated utilities. Because regions with organized wholesale electricity markets contain the majority of generation capacity and load nationwide,2 this report focuses its attention there. Particularly in regions where generators recover their costs of investing in generation capacity through organized wholesale markets rather than pursuant to state-regulated integrated resource planning (IRP), the structure and operation of those wholesale markets makes ensuring resource adequacy relatively complex.3 Most importantly, those markets must provide sufficiently strong investment signals to generation owners to build an adequate fleet of resources. By contrast, in regions without organized wholesale markets, resource adequacy mechanisms involve bilateral contracting, with state economic regulators (in coordination with vertically integrated utility companies) deciding what resources to build and maintain through administrative processes and competitive procurements.

click to enlarge

Resource Adequacy Basics

Electricity’s characteristics complicate the task of constantly matching supply and demand to maintain resource adequacy—for one, it is expensive to store electricity in large quantities. Consequently, maintaining resource adequacy necessitates correctly predicting patterns of both supply and demand. On the supply side, this requires evaluating what amount of electricity diverse available resources—ranging from conventional power plants, to utility-scale renewables, to flexible and distributed resources—will be capable of providing when required. This evaluation cannot simply add up resources’ maximum outputs under conditions specified by the manufacturer (termed “nameplate capacity”). Instead, it involves specifying each resource’s maximum possible output in the conditions particular to the times and place in which it actually operates. On the demand side predictions can also be challenging because key demand-side inputs, such as the timing, frequency, intensity, and duration of weather events, can never be known in advance, but those events can spark dramatic spikes in electricity consumption to levels well above normal. Further, the adoption rates for technologies like electric vehicles and rooftop solar are hard to predict with precision, but those technologies significantly change load patterns and make them more dynamic, compounding the challenge of forecasting electricity demand.

These inherent uncertainties make it prohibitively expensive to ensure that there is always sufficient generating capacity to prevent any outage. Even in a situation where capacity significantly exceeds expected demand, a combination of unexpected occurrences could still cause consumption to surge and limit grid operators’ ability to meet it with operational resources. So, in practice, approaches to maintaining resource adequacy aim to keep the frequency of outages due to insufficient generation capacity below a certain level, rather than to prevent them completely. On pages 19-23, this report discusses how an August 2020 heatwave and February 2021 cold snap caused events of this sort in California and Texas respectively.

“Market design” is a term used to describe the rules and incentive structures that are meant to translate resource adequacy specifications, such as a planning reserve margin, into investments and operational capabilities. Regions’ approaches to market design and compensation are more diverse than their choices of reliability standard. This is not only true from one country to another—even within the United States regions’ approaches vary, with the two most important approaches being energy-only and energy-plus-capacity markets. In all regions, however, the imperative to maintain a resource fleet capable of meeting aggregate demand is complicated by features of the electricity marketplace, such as time-invariant retail rates that make demand unresponsive to changes in supply and the imposition of legal obligations to serve consumer demand. Market designs intended to solve the resource adequacy problem need to strike a workable balance between the competing priorities and obligations under which electricity market stakeholders operate.

click to enlarge

Renewables’ Proliferation and Resource Adequacy

The proliferation of renewables is sure to effectuate changes to important features of electricity markets, and so may require adjustments to legacy approaches to resource adequacy as well. Renewables’ operational characteristics modify the short- and long-term supply-side uncertainties at play in wholesale electricity markets. In particular, renewable generation is variable across seasons and days as well as being intermittent, meaning that its output level depends on external conditions such as weather and cannot be fully controlled. These features make it somewhat harder to know how much renewable generation will be available at any given moment, especially when planning years in advance.13 (Notably, however, renewables’ presence also mitigates some supply-side uncertainties, such as fuel supply.) Additionally, prevalent renewables can reduce energy prices because, once they are built and connected to the grid, it costs very little for them to produce an additional unit of energy as they have no fuel input costs. The resulting price changes can affect investment incentives—though, as explained below, concerns about adverse consequences of this effect tend to be overblown.

The potential need to modify design elements of the electric grid and wholesale markets that were originally crafted with conventional resources in mind will intensify in the coming years, given renewables’ growth. Regulators have been investigating whether and how different approaches to resource adequacy are compatible with high levels of renewables deployment, and blackouts in California in August 2020 and in Texas in February 2021—discussed in depth below— have turned public attention to that and related issues as well. By grounding its analysis in the findings of economic research, this report seeks to contribute rigorous conclusions and insights to these debates.

click to enlarge

Clean Energy Policies and Resource Adequacy

Renewables can potentially affect the functioning of resource adequacy mechanisms but the reverse is also true: the choice of resource adequacy mechanism can meaningfully influence the scale and pace of investments in renewables.

For instance, in several regions, the rules governing resource adequacy have been applied in ways that significantly undermine states’ support for the deployment of renewables and energy storage, and thereby help to protect the share of wholesale capacity market revenues flowing to fossil-fueled resources.20 The adoption of such rules in three wholesale trading regions—PJM, ISO-New England, and New York ISO21—has been criticized for creating market barriers for renewable generation and storage, impairing market efficiency, and raising consumer costs.22 Similarly, a recent fuelsecurity proceeding in ISO-New England threatened to reshape the approach to resource adequacy in that region23 in a way that would boost revenues paid to fossil-fueled and nuclear resources to the detriment of renewables.24

The interactions between renewables and resource adequacy in regions with organized wholesale electricity markets will be particularly consequential for climate goals. The success of power sector decarbonization efforts hinges on outcomes in the wholesale trading regions administered by Regional Transmission Operators (RTOs).25 These regions house the major coastal and midcontinent urban load centers, making them responsible for the majority of U.S. electricity sector carbon emissions.26 And there is a great deal of overlap between regions with wholesale electricity markets and states that already have explicit clean energy goals in place (see Figure 1). Wholesale markets’ approaches to resource adequacy will therefore inevitably interact with state-level clean energy goals.

click to enlarge

Proposed Novel Approaches to Resource Adequacy

Currently, policymakers and stakeholders are engaged in an active conversation about how best to pursue the interacting objectives of ensuring resource adequacy and enabling the rapid deployment of renewables—all without driving up the costs ultimately paid by consumers. Various proposed approaches have been presented in academic circles, as well as to state governments and RTOs and their stakeholders. For instance, New Jersey is considering new market designs for wresting control over resource adequacy within its borders from PJM. New York is exploring a similar reclamation of authority over resource adequacy from its RTO, NYISO. In ISO-NE there is also a push for capacity market reforms, and innovative market designs with long-term resource adequacy contracts were discussed at a December 2020 academic conference. The proposals are diverse. Table 1 lists three illustrative examples; it is not comprehensive.

Like this report, these proposals all consider how ensuring resource adequacy at reasonable cost interacts with ongoing, and accelerating, renewables deployment. But whereas these proposals would add new mechanisms to existing market structures or provide novel combinations of existing mechanisms, this report’s recommendations focus on adjustments that could be made to existing market mechanisms in their current configurations. Even though we recognize that our recommendations and these novel proposals are potentially compatible, we do not analyze their merits…

click to enlarge

Conclusion

Wholesale electricity market design cannot ignore the burgeoning transition to a clean electric grid—a transition driven primarily by the deployment of variable renewable resources. To ensure that wholesale markets continue to provide for resource adequacy, while minimizing the total cost of providing electricity as this transition accelerates, policymakers responsible for market design decisions should undertake a critical examination and updating of existing market mechanisms. Notably, the oldest capacity markets in the United States are about 20 years old and the modern energy markets are not much older. Those markets have continued to evolve since they were first established; they are flexible structures that can be adapted to new circumstances.

While recognizing that a growing share of renewables will surely change market outcomes, this report is grounded in the premise that more prevalent renewables will not change the fundamental principles that inform efficient market design—for instance, that market participants should face efficient price signals. Implementing these principles will never be simple or easy, however.

This report does not identify one best way to ensure resource adequacy, and instead recognizes that different resource adequacy approaches can, in principle, achieve similar outcomes. However, even small differences in market design can cause the outcomes of individual resource adequacy approaches to diverge. While this report leaves open the question of which design a given region should adopt, it does highlight important considerations for ensuring that a given energy-plus-capacity design does not tilt the competitive field against renewables. It also indicates possible improvements for energy-only systems. This report’s findings take two forms.

The first set of findings identifies design elements in existing capacity markets that put renewables at a competitive disadvantage and thus deserve, at minimum, critical attention, and, ideally, correction.

• Asymmetric risk treatment

• Measurement of renewables’ capacity contributions

• Non-neutral operational requirements

• Non-neutral obligation periods

• Minimum Offer Price Rules that target renewables.

In addition to identifying evident pitfalls, this report also points to several measures that can make way for a rising tide of renewables while yet ensuring that resource adequacy is maintained at reasonable cost:

• Improve energy price formation

• Establish appropriately downward-sloping capacity demand curves for energy-plus-capacity markets

• Encourage flexibility of electricity demand

• Update capacity products and capacity crediting for energy-plus-capacity markets

• Update performance penalties and rewards for energy-plus-capacity markets

• Cease applying Minimum Offer Price Rules to neutralize state clean energy policies in capacity markets

• Expand the set of hedging tools available in financial markets.

In the long term, market designs for resource adequacy may undergo an overhaul of the sort suggested by proposals like those listed in Table 1. Should that come to pass, the measures listed above could serve not only as steps to take but as criteria by which to evaluate the merits of a given proposal.

Tweet