Switched on to electricity capacity

By John Dizard

John Dizard sings the body electric of energy-demand markets

We like obscure markets here; not only do they tend to be more intrinsically interesting, but they’re about the only places where you can make real money any more.

US investment grade corporate bonds are yielding 2 per cent, with the risk of loss on inflation. Equities give you the same 2 per cent, paid out of corporate profits that are at historic peaks. There’s no way, apart from the usual deceptive benchmarking in reports to clients, to earn any value added by buying this stuff.

As for “low risk” arbitrages, they’re more overdeveloped than a doped-up American in the Tour de France. Any detectable mispricings within or between markets will be sucked away in milliseconds by heartless algorithms.

So I’m always looking in trackless wastes or urban ruins for some clumsy, under-designed markets. Among those that have interested me lately are the US markets for electricity “capacity”, as distinct from “energy”. These are just in the process of being designed, or having the original kinks straightened out – and, what’s more, new market participants could actually perform a useful social function by providing price discovery and financing for the necessary equipment. Imagine that. And there are billions of dollars, out of the $100bn or so in annual electricity capital budgets, prospectively at stake – with good counterparty risk profiles.

A bit of clarification may be in order. Electric energy is what makes motors, lights and integrated circuits work. Capacity is the ability to deliver that energy at a specified level, reliably, at specific points in space and time. For example, electricity people will make statements such as: “Wind is an energy product, not a capacity product.” That means that while wind turbines should produce the promised energy over the course of a year, they don’t necessarily do so when you want it, or they do produce it when you don’t want it. When there are a lot of wind turbines on a grid, such as there are in Texas, their up-and-down cycling has to be countered by cycling of gas turbines, or in Danish, Swedish or Norwegian hydro plants.

This can get expensive, and worse, unreliable. In Texas, the production subsidies given to wind turbines through the tax system mean that they can displace so much base load (in effect, fixed output) fossil fuel generation that during some off-peak hours there are negative prices for electricity. That’s right, you have to pay the grid in order to have your power accepted. This sounds like money for nothing, but unfortunately it leads to insufficient new, predictably available, generation being built. Texas’s high growth rate is now bumping up close to the limits of its electric generating capacity.

In contrast, the biggest electric grid in the US, the PJM grid, which serves 60m people in the northeast, mid-Atlantic region and part of the Midwest, has had a capacity market for some years. There is far less risk of a lack of generation capacity in PJM than in Texas. The PJM forward capacity market, called the Reliability Pricing Model, is quite complex, but arguably not yet fully formed. Yet its series of auctions for generation capacity has helped the coal-dependent grid to get past environmental rule-driven retirements of high-pollutant coal plants.

The PJM grid also includes wind (and solar) plants, but not in quite as high proportions as the Texas grid. These renewable sources are being rapidly outstripped by the growth of what is called Demand Response, or DR, by which electricity consumers agree to have their power use curtailed when the grid runs close to the limits of its reliability.

That sounds very, very green. If the wind isn’t blowing or the sun isn’t shining, then we just cut back on our use of refrigerators, computers or air-conditioners.

Or maybe not. This is where capacity markets may require a few more design tweaks. You see, if a regulated utility, or a large generating company licensed to sell power into a competitive market, commits itself to providing generation capacity from a specific date, then it had better do so with some real steel in the ground. Otherwise, various federal and state agencies will want to know why.

On the other hand, if you’re a consumer, such as the owner of a shopping mall, office building or factory, you can promise to make your power available for interruption without having to prove your willingness or ability to do so. You can also, according to serious PJM market observers, sell DR capacity for delivery in, say, three years at a high price, then sell it back a year or two later at a lower price. In other words, a nice arbitrage.

Not only that, but the same large consumer can sell DR capacity in forward auctions, use the cash to buy a diesel generator, and then run the diesel generator for up to 100 hours a year at a lower cost than the summer peak rates.

You, the office park or factory owner, are literally being paid to put out more carbon and particulates than the coal plants shut down by the EPA.

This is one reason why back-up generators are
one of the most dynamic industrial sectors in the US.

Diesel generation
may comprise as much as half the “green” demand response on the PJM grid. The diesel back-up exception allowed by the Environmental Protection Agency is being challenged by generation groups and the usual enviros, but the odds are it stays in place. Eventually, the PJM authorities – who are thorough, if understandably cautious, about changes to the rules – will plug some of these gaps.

As more renewable generation and demand response is put in place, new capacity markets are likely to be put in place, not only in Texas, but in California, the Midwest and elsewhere.

Why doesn’t any of the genius that goes into forex or euro area bond markets try to figure how to make them more efficient, yet still profitable?

john.dizard@ft.com