A Dynamic Analysis of a Demand Curve-Based Capacity Market Proposal: The PJM Reliability Pricing Model

Because of high generation adequacy standards in the power industry, some peaking capacity operates for a limited time during the year and may not receive sufficient energy revenues to meet its fixed costs. This is particularly true when energy prices are capped in order to mitigate market power. The northeastern U.S. independent system operators (ISOs) have responded to this issue by establishing capacity obligations for loads and markets for installed capacity, thus providing a capacity revenue stream to generators. The installed capacity (ICAP) markets in the northeastern U.S. markets are a response to this need for additional incentives to construct generation. The Federal Energy Regulatory Commission (FERC) has accepted the PJM Interconnection's (PJM) proposal to replace the present fixed ICAP requirement that is placed upon load serving entities (LSEs) with a demand curve-based system in which the ISO would be responsible for acquiring "residual" capacity on behalf of LSEs. The demand curve approach pays more when reserve margins are smaller and provides a reduced incentive for investment when installed reserves are above the target. Another goal is to make revenues more predictable for generators, making investment less costly and, ultimately, lowering prices for consumers. A dynamic representative agent model is presented for projecting effects upon reserve margins, generator profitability, and consumer costs and is applied to alternative demand curves proposed for the PJM market. The consumer costs resulting from a sloped demand curve are robustly lower compared to the present fixed requirement under a wide range of assumptions concerning behavior of generation owners, including risk attitudes, bidding behavior, and willingness to build capacity as a function of forecast profit. The cost savings arise from lower capital costs to generators due to reduced risk and risk premiums. Also, average installed capacity is less for the same level of reliability because of reduced fluctuations in installed reserves