The inconvenient truth of energy policy

We can’t reduce emissions and keep prices down

THE MASSACHUSETTS LEGISLATURE just enacted some of the most ambitious clean energy procurement legislation in the nation.  It is a significant step to meet the Commonwealth’s emissions reduction goals and a major victory for the environmental community and offshore wind industry.  It also was an important accomplishment for the Baker-Polito Administration to bring large-scale hydro into the mix to address our clean energy needs.  But make no mistake about what is about to occur from a market perspective. The volumes of energy that will be purchased by the investor-owned utilities under long-term contracts are massive. And those contracts likely will come at above-market prices – even for large-scale hydro, when the transmission costs are included.  While hydro will come at much lower cost than offshore wind, it still is likely to be above market when compared to wholesale energy prices that averaged only 4 to 6 cents per kilowatt-hour over the past two years. While some may be concerned about the cost, it is the price to achieve the benefits of lower greenhouse gas emissions in the battle against climate change.  But this ambitious carbon-reduction initiative also brings with it another major challenge, as it relates to the impact these procurements will have on the regional electricity markets.

Specifically, the introduction of large amounts of energy into the market from the long-term procurements will have ripple effects as those large-scale projects come on line.  It is the consequence of a collision between the environmental objectives pursued under state law and the environmentally-blind operation of the regional market rules that falls under federal law.  If left unmitigated, it has the potential to undermine the objective of the legislative initiative over the long term and threaten the integrity of our wholesale electricity markets that provide the revenue necessary for the regional generation fleet to keep the lights on.

A brief overview of how the energy market works places the issue in context.  In general, market prices are set by competitive bidding systems.  While there are many complex rules associated with the bidding and dispatch of generation in the market administered by ISO New England, the concept is fairly straightforward in the energy market.  In simplified terms, the ISO identifies how much generation is needed in every hour, and generators submit bids to supply the energy.  Some frequently-running generators that do not have the flexibility to ramp up-and-down over the hours of each day (like nuclear units) are “price takers,” meaning they will get whatever the market price may be.  But most traditional generators submit bids that relate to their marginal costs, which are made up largely of incremental fuel cost.  Renewable generators such as wind have no fuel cost.  For that reason, they typically participate as price takers in the market. Bids from participating generators are accepted from the lowest to highest until the ISO requirement is met for the applicable period.  The bid of the last generator selected sets the market price of energy for that period for all bidders clearing the market.

So how does this relate to the new large commitments that will be made through long-term contracts?  When large quantities of electricity are brought to the market through long-term contracts, the contracted energy will not be bid at its actual cost because the supplier of that energy is getting its revenue from the contract.  Rather, it enters the market like a price taker, causing higher cost generation at the top of the ISO market bidding stack to be displaced, leaving generation with lower marginal cost setting the market price of energy for all generators.  As a result, wholesale energy prices are suppressed.  When the wholesale energy prices stay low for long periods, it can create financial strains on many generators participating in the market because they receive much less revenue to operate their units.

Price suppression is not a bad thing in a properly functioning market when more efficient generators are simply bidding at low marginal cost, causing market prices to fall.  This effect also is referred to as “production cost savings.”  But in the case of large quantities of energy being injected into the market from long-term contracts, the “production cost savings” are due to the contracts funded by Massachusetts ratepayers who are paying for these higher cost resources to obtain the environmental benefits. Massachusetts pays above-market prices for the clean energy, and wholesale energy prices for the entire region drop from the market effect. Many have viewed this suppression of energy prices caused by the long-term contracts as a benefit.  In fact, we repeatedly see project proponents of clean energy resources pointing to regional price suppression as a long-term benefit. But it is highly uncertain that net regional savings will endure over the long term. Further, in the case of offshore wind, the cost of the contracts will be much larger than Massachusetts’ share of any regional production cost savings.

In 2015, the ISO published a discussion paper about the impact of renewable resources on the regional markets, including both the energy and forward capacity markets. The forward capacity market is the other primary wholesale electricity product upon which generators rely.  While the energy market compensates generators based on their production in real time, revenue from the forward capacity market comes in the form of fixed monthly payments.  This market is designed to assure that there is enough generation to meet future peak demands. The capacity prices are set three years in advance through a highly complex bidding system. The ISO paper suggested that the suppression of energy prices caused by renewable resources will gradually cause price increases in the forward capacity market, as bidders realize they need more revenue from the capacity market to operate. If the ISO paper is right, much of the energy price suppression savings from the long-term contracts would be netted out from higher capacity costs over the long term.

Other market participants, however, have a different view.  Some believe that future regulators will not have the political will to allow capacity prices to rise so significantly.  Here too, there is much history among the market participants that has left few fully satisfied.  A perennial tug-of-war seems to occur.  Among a multitude of other technical issues and stakeholders, generators are concerned about capacity price suppression (in addition to energy price suppression), others are concerned about preventing the exercise of market power, and consumer advocates are concerned that the system results in too much capacity being purchased at too high a price.  As a result, we are left with bidding rules of mind-boggling complexity. And the collision of views results in frequent litigation that creates substantial market uncertainty.

Most important from an emissions-reduction perspective, the market uncertainty creates a real risk that the nuclear units in the region will not be able to stay in business over the long term because they are highly dependent upon energy revenues to cover their high operating costs.  And this should be a concern of everyone.  While nuclear power produces radioactive waste and often raises other concerns, many environmental advocates are now recognizing the important role that nuclear units play in meeting greenhouse gas emissions reduction targets because nuclear power does not produce greenhouse gas emissions. Nobody is putting “Save the Nukes” bumper stickers over the old “No Nukes” bumper stickers from the 1980s, but the impact of greenhouse gas emissions has begun to outweigh concerns about the risks of nuclear power in many environmental circles.

Of course, Pilgrim Station is already closing.  Given its age and rocky track record of late, it is probably closing at the right time. But the same should not be said for the Seabrook and Millstone units located in New Hampshire and Connecticut. If those nuclear units were to close, it will substantially set back other gains made to reduce greenhouse gas emissions in the region, as fossil fuel generation inevitably replaces the nuclear energy. In the near term, it may not appear to be an issue. The scheduled rise in capacity prices that will take effect during the next few years from the most recent forward capacity market auctions, combined with spiking winter energy prices, should keep these nuclear units financially sound at least through 2020.  But we have a longer term problem for the next decade after the large-scale clean energy projects begin to reach commercial operation. And even if there was a gradual shift of revenue from the energy market to the capacity market, it could be far too late and not enough to keep on line the nuclear units that depend heavily on energy revenue.  As such, if we ignore the market distortions, we risk having fossil fuel units filling the gap for more firm generation at the back end of the next decade.  From an emissions-reduction perspective, it would be like one step forward, two steps backward.

In part, these impacts explain why the New England Power Generators Association (NEPGA) was so adamantly opposed to the large-scale hydro procurement in the energy legislation. Perhaps the power generators did not always articulate the issue in well-understood terms.  It often appeared that they were just complaining about higher costs to consumers from above-market contracts or the perceived economic unfairness of sending dollars to Canada. To many observers, these arguments seemed detached from the association’s core interests. But the power generators did have an important point to make about market impacts. Nevertheless, the answer was not to stop the environmental initiatives, as the association sought to do.  Pure market solutions alone will not be enough because we need long-term contracts to finance clean energy.  Rather, taking long-term contracts as a given, we need to pursue companion solutions on other fronts.  One solution may be to create more stringent targets under the Regional Greenhouse Gas Initiative, if politically feasible.  But another one is to make adjustments to the regional market system.

The generators represented by New England Power Generators Association may have lost the fight to stop the energy bill, but it is time to pay close attention to the market distortion issues underlying their opposition. Re-aligning and transitioning the wholesale markets over the long term should become an immediate companion priority to the implementation of initiatives that are specifically intended to reduce greenhouse gas emissions. Unlike the clean energy resource initiatives just enacted, however, this is not a matter for state legislation. Rather, it is one that calls for negotiated solutions in the ISO stakeholder processes to which federal law applies.

ISO stakeholder processes have traditionally been difficult to navigate.  But representatives of the New England states, the ISO, and market participants are taking these issues seriously and an effort is underway to examine potential solutions. While trying to change the regional market rules is often harder than herding cats in the corner of a barnyard, some form of market change is needed that adequately compensates generation that is required for reliability and keeps the remaining nuclear units in New Hampshire and Connecticut financially healthy over the long term.  If we do not do this, we risk missing the mark on our ambitious emissions reduction goals.  Adjusting the rules may put upward pressure on wholesale electricity costs in the regional market beyond the cost of clean energy.  But it would represent the cost of assuring a low carbon future in the electric sector that does not compromise reliability.

We need to confront an inconvenient reality in our policy making.  We cannot expect to keep wholesale electricity costs low while substantially reducing greenhouse gas emissions and maintaining around-the-clock reliability at the same time.  That is like trying to sail a ship in two directions at once.  Reducing emissions and maintaining reliability will inevitably come at a higher cost than we are seeing today and we need a properly functioning regional market to assure that the evolution to a low-carbon electric system is not disrupted by the market distortions. But it will take market adjustments to get there. Otherwise, we may find the regional ship sailing in an unintended direction after it is too late to turn the ship around.

Meet the Author
Ron Gerwatowski recently served as assistant secretary for energy during the first year of the Baker-Polito administration. After his stint in state government, he returned to the private sector as an energy and regulatory policy consultant. He was formerly senior vice president for regulation and pricing at National Grid before retiring from the company in early 2014.

  • Mike Hachey

    What’s especially inconvenient is the message the governor and legislature have sent to the courageous manufacturers in Massachusetts: Don’t Make It in Massachusetts! Manufacturing is especially sensitive to the cost of energy, and manufacturers already bear a state policy “premium” of about 3 cents/kWh on top of the actual cost of energy of 4 cents/kWh. The energy bill carries a financial burden to ratepayers of somewhere between $20 and $30 Billion dollars. You might think that, given Beacon Hill’s proximity to some of the best universities in the country, before a legislative commitment of this magnitude was made, extensive due diligence and expert consideration would be undertaken on the best way to proceed. That’s what would happen in the private sector. But remember, this is Massachusetts state government. So instead, lobbyists, special interests that directly benefit from the bill, and politicians with precious little energy or market expertise work behind closed doors to craft a bill that works very well for those lobbyists and special interests. But the Massachusetts manufacturers? Other Massachusetts ratepayers? Pound sand!
    Let’s look at some more inconvenient facts. Between 1990 and 2013, carbon emissions from Massachusetts power plants have dropped by 51%, from 25.7 to 12.6 MMT. Residential heating at 13.6 MMT now exceeds power plant emissions, and transportation emissions are a whopping 29.1 MMT, more than twice the magnitude of power plant emissions. There is certainly no carbon crisis in the Massachusetts electric sector.
    Offshore wind is the most expensive way to make electric power. For the 1600 MW called for in the bill, creditable capacity is less than 300 MW. This is a very expensive frill for a few south coast politicians.
    The author is right that simply stuffing large volumes of new energy into a market balanced between supply and demand threatens the viability of more efficient market competitors, likely the nuclear plants. Accordingly, the hydropower purchase will accomplish nothing beneficial – no net reduction in carbon emissions, no energy diversity. What it will do is increase electric rates, provide $200 – $300 Million in “incentive” payments to utilities, boost corporate earnings from transmission construction, subsidize the Quebec government, eliminate New England plant jobs, and terminate property taxes to towns that host those plants.

    • Jan Galkowski

      Offshore wind is NOT the most expensive way to generate electrical power, as judged by many standards such as Lazard’s Levelized Cost of Energy (LCoE) analysis. (See https://goo.gl/YKw4VE) Even unsubsidized, offshore wind overlaps with natural gas for generation, especially natural gas peaking plants, which are also dirty compared to others, the kind that would be brought online during the much talked about price pinches in winter.

      Indeed, if cost of electricity is the key determiner of policy, then the Commonwealth and its citizens should be rushing headlong into the arms of ONSHORE WIND which, despite its unpopularity in some circles for aesthetic reasons, has an unsubsidized costs which is competitive with or cheaper than baseload generation by natural gas. So, if electrical energy costs are the key thing, onshore wind should dominate aesthetic concerns.

      And, yes, other sectors, like transport, are big contributors to greenhouse gas pollution, and that is especially a concern with respect to the Global Warming Solutions Act (GWSA). However, the sensible way of dealing with emissions in these other sectors is TO ELECTRIFY THEM, since the electric sector has done such a good job.

      And, in addition, the part of the problem not admitted in the above article, is that Massachusetts electric rates are some of the highest because the per capita consumption of electricity in Massachusetts is among the lower. So ALL that overhead for ISO-NE and the utilities and the supposedly efficient market gets spread over lower amounts of consumption, so the price per KWh is higher. This is the same reason why Hawaii has such high electrical costs, and Wyoming has such low ones.

      Unstated in all this is that true electricity competition should include the newcomers in a big way: A liberalized solar generation policy, especially for the community solar and storage that places like Minster, OH (see http://goo.gl/ur9f4s) have been able to procure, for people who cannot afford solar on their roofs, or have trees, or live in multifamily situations. And then we’ll see real competition: The big, old 20th century utility grids, reluctant to update, against efficient modern distributed grids, power put on lines to feed neighborhoods, from solar, and local wind. New York State is heading that way.

      Also ISO-NE can see is a centralized plan doing business-as-usual. The world is changing, like it or not. If managers at generators and utilities can’t bring their prices down, they’ll see customer defection.

  • fred02138

    An excellent exposition of some complex issues. The new energy bill directs the DOER to require utilities to develop storage systems by 2020. If this takes off, how will it affect the energy market? As renewable capacity increases, the ability to deploy stored energy to the grid should mitigate the negative effects of wholesale price suppression, no?

    • Ron Gerwatowski

      Hello Fred: Storage is beginning to show promise, but it will probably take more years beyond 2020 to get large-scale deployment throughout New England. Even then, storage typically would be used to shave peaks. Absent fast-paced innovation and advancement, it is not likely to run for many hours at a time. Peak shaving would have two effects. First, it could reduce capacity prices in the future if enough large-scale storage participates in the forward capacity market. Second, it would typically be dispatched when energy prices are at their highest. So it would have the effect of lowering capacity prices and energy prices if deployed widely. In other words, it would contribute to (not mitigate) price suppression in both markets. Ironically, because storage would be funded through incentives that are ultimately paid through electric rates by Massachusetts consumers, it is similar to the long-term contracting discussed in the article. However, even though storage is beginning to show promise, it is unclear how much as a practical matter can be deployed over the next five years. It is still an expensive resource that would need incentive programs funded by ratepayers. The utilities implement, but the costs flow to consumers. The program designed by DOER is more likely to start slow and build up over time. But as a practical matter – unlike the long-term contracting – the cost of deployment probably means that Massachusetts would not be in a position to subsidize the regional markets with large enough deployments to make a significant regional market difference through this state alone. I think the storage section of the legislation was just a means of stimulating the market for storage development. I hope I answered your question, but tough to do on the fly. Best, Ron

  • NortheasternEE

    Cape Wind failed because the long term contracts utilities were forced to sign at 4 to 6 times above the going rate. The deep water offshore wind power ordered by Beacon Hill will be at even higher prices. From the stand point of reliability, intermittent and variable wind power needs firming from load following simple cycle natural gas power plants that pollute at twice the rate of combined cycle baseload power plants.
    In the absence of mass storage, whose cost and availability is unknown, this is a huge gamble. Beacon Hill’s energy legislation is forcing the early retirement of clean nuclear power to be replaced by a combination of offshore wind and natural gas, a change that increases CO2 emissions. Ratepayers will be forced to pay extra for new pipelines, transmission lines, and storage(if it ever comes).
    Rates will skyrocket. Emissions will stay the same or increase. Manufacturing jobs will go elsewhere. This intervention by Beacon Hill on the competitive market for electricity will not deliver on its promise.

    • Jan Galkowski

      In fact, manufacturing jobs will go elsewhere if the Commonwealth does NOT aggressively pursue zero Carbon energy, because manufacturing companies are being increasingly held to sustainability goals and challenges by their investors. And there are two strong choices right next door: New York State and Rhode Island.

      Rates may skyrocket FOR THE PEOPLE CHOOSING TO REMAIN ON THE CONVENTIONAL GRID. But, then, they don’t have to stay there.

  • ThisOldMan

    Over the next ten-to-twenty years, I expect that the problems raised in this article will be largely solved by “Virtual Power Plants,” which manage demand instead of supply (http://en.wikipedia.org/wiki/Virtual_power_plant). The commercial viability of this approach has been well established by companies such as EnerNOC (http://en.wikipedia.org/wiki/Demand_response), but not on the scale that will be needed to integrate large amounts of renewables in the long run. Doing so in a cost effective manner will require the utilization and automated dispatch of preexisting distributed assets which, although not purchased specifically for energy storage, can in many cases serve much the same purpose. Such assets include electric hot water heaters (going forward, these will be largely heat-pump driven), ice-based cold thermal energy storage, and of course electric vehicles which will be largely charged at night and so, once deployed at scale, will also help keep those nukes in business (see http://en.wikipedia.org/wiki/Sustainable_community_energy_system). Although once we get good at good at this sort of thing, the nukes won’t be needed any more.