spark spreads, marginal costs and long-term reliability

Laurence E. Skinner, Paul, Hastings, Janofsky & Walker

It is tempting to conclude, based on the published spark spreads for natural gas-fired generators, that the owners of nuclear and coal-fired generating facilities must be making windfall profits in the power markets and that regulators must now take action to protect consumers. Such a conclusion would be misguided because it reflects the factually incorrect assumption that the output of nuclear and coal-fired generating facilities is always sold at market-clearing prices based on gas generation; it ignores the role of prices in competitive markets; and it runs contrary to the need for new generation to satisfy reliability criteria.

Spark spreads-the difference between the price of electricity and the variable cost to produce that electricity-are, in competitive markets, based on the marginal costs of the last unit of electricity necessary to meet market demands at a given time. In a market such as PJM, the spark spread would be based on the locational marginal price that is paid to all the suppliers participating in the market.

Only the generators participating in the market receive market-clearing prices. In PJM, not all of the resources serving loads were selling at locational marginal prices through the PJM day-ahead and real-time energy markets. According to the 2005 State of the Market Report for PJM, about 31.3 percent of the day-ahead load and 40.4 percent of the real-time load cleared through those markets. Because nuclear and coal-fired generating resources provided 90.6 percent of the electricity generated in PJM during 2005, clearly much of the output of those resources was not sold through the market.

Even if the output of all nuclear and coal-fired generating facilities was to be sold at market-clearing prices, one cannot conclude that the owners of those facilities are being overpaid even though their variable costs of producing electricity are below the costs of gas-fired generation. There are several ways to understand this.

Theoretically, competitive pricing principles indicate that prices in competitive markets tend to equal marginal costs. With marginal cost pricing, consumers receive prices that reflect the cost of additional demand and suppliers receive price signals about what resources can be supported in the market. Paying all of the participants in a market on a marginal cost basis is the outcome expected from competition. Of course, relying on economic theories may not be satisfying to everyone.

Consider the results of cost-of-service ratemaking. A utility would be allowed to charge prices that compensated it for its total cost of providing service, including the variable costs incurred to produce electricity (i.e., its marginal costs) and its fixed costs, including a return of and on the investment made in the assets needed to generate and deliver that electricity. If the only compensation received by a generation owner is through the market-clearing price of energy (i.e., there is not a robust capacity payment available to generators), then the spark spread between those market-clearing prices and its variable cost of generation must be sufficient over time to allow the generation owner to recover its fixed costs, otherwise that generation owner will be unable to stay in business. The fact that there are times when the market clears at prices higher than the marginal cost of a nuclear or coal unit merely means that those units have the opportunity to cover other costs and to earn a return of and on investment. It does not necessarily follow that windfall profits are being earned.

There are times when coal-fired generation is on the margin, when the market-clearing price is being set based on the marginal costs of a coal-fired unit and no real profit is being earned by those generation owners. In PJM, coal-fired generation was on the margin 62 percent of the time during 2005.

Ultimately, there is a market proof of whether windfall profits are being earned. When profits are high, there are new entrants into a market. But there hasn’t been a rush to build new nuclear and coal-fired generating capacity. In fact, the pace at which new capacity is being proposed has raised concerns about long-term resource adequacy, concerns which are exacerbated by the fact that the introduction of new base-load and intermediate capacity has a lead time counted in years.

PJM is concerned about longterm resource adequacy, even though it has marginal cost market-clearing pricing in place. In 2005, the generating resources available to serve load within PJM were, on occasion, inadequate, resulting in the use of emergency procedures to prevent the loss of load. This situation is a direct indication that the price signals to generation owners have not been adequate to draw resources into the market.

When the owners of nuclear and coal-fired generating units are paid prices based on the marginal costs of gas-fired generators, there is an opportunity for them to recover fixed costs and to earn a return of and on their investment. That opportunity is necessary not only for those units to remain in service but to provide an incentive for new base-load generation to enter the market. When there are questions about long-term resource adequacy despite those incentives, it is not the time to raise ill-founded claims of windfall profits that could create uncertainty in the market.

Laurence Skinner is a partner and member of the Global Project Finance Group of Paul, Hastings, Janofsky & Walker. The views expressed are his.

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