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.

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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.

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.