To meet the state's growing electricity demand, Texas regulators are considering a "capacity market" -- a mechanism which forces customers to subsidize power plants which aren't economically viable under normal market forces, and which have added billions of dollars to electric bills in the Northeast.

As has previously noted, Texas is forecast to have insufficient generating capacity to meet its electric demand in a few years.  To incent the building of new generation, the Public Utility Commission (PUC) recently raised the electric market wholesale price cap to $4,500/MWh, from $3,000/MWh.

However, generators claim that this 50% increase in the price cap is not enough to assure enough generating capacity, and are seeking introduction of a mechanism called a "capacity market."  Based on experiences in other states with a capacity market, introduction of a capacity market in Texas would be disastrous, forcing customers to pay billions of extra dollars in costs, while not leading to the building of new power plants or any greater assurance of adequate generating capacity.

One of the reasons Texas' electric rates are so low is that customers have been completely freed from any obligation to pay for generating capacity.  Texans only pay for the energy they consume, and generators only get paid when they produce electricity, maximizing efficiency.

A capacity market changes that.  A capacity market obligates all customers in the market to buy "capacity" -- which is a fictional product that customers do not consume like electric energy.  When customers are forced to buy capacity, it commits them to, three years in the future, pay a set amount of costs to power plants, ostensibly to cover these plants' fixed costs.  In exchange for these payments, customers only get an assurance that these plants will be online in three years, but customers do not receive any energy from these plants in exchange for their payments -- customers still have to separately pay for the energy they consume on top of these capacity payments!

Proponents of capacity markets argue that committing to pay power plants' fixed costs in the future assures customers that these plants won't retire, and will be available to meet demand.

However, this assurance comes at a high cost.  One of the major flaws of a capacity market is that all generators get paid a capacity payment -- even those that are low cost and are not in any danger of retirement.  Rather than just providing "missing money" to generators who only operate during super-peak times and face challenges in recovering their costs due to infrequent run-times, the capacity market provides a windfall to all generators for simply existing, regardless of whether they produce power.

The Texas Industrial Energy Consumers (TIEC) have protested calls for a capacity market because of the billions it would add to Texans' electric bills.  Indeed, the experience in the Northeast states, like Maryland, New Jersey, and Pennsylvania, have shown that capacity markets substantially increase electric rates.  As of June 2012 (using Energy Information Administration data), Texas had a lower average all-in electric rate (11 cents) than any state with a capacity market, where rates are as high as 17 cents -- a whopping 50% higher.

Since a capacity market was introduced in the Mid-Atlantic states in 2007, "it has cost customers approximately $50 billion (through the end of 2011)," TIEC noted, which is approximately $900 per person in the 13-state area.  "New Jersey and Maryland are now attempting to finance and build state-owned generation resources to satisfy their mandated capacity obligations because it is significantly cheaper than paying the annual PJM capacity payments. This is strong evidence that a capacity market does not lead to rational or efficient results," TIEC said.

"TIEC estimates that imposing a capacity market on ERCOT would be extremely costly, with little to no benefit. Some have argued that capacity payments and energy revenues are two interchangeable means of incentivizing the same level of reserves and, all things being equal, the same total costs should result regardless of which revenues come from which revenue stream. This assertion ignores the extreme difficulty and complexity of recreating the natural incentives of a competitive market through administrative requirements," TIEC said.

"This would be a substantial step backward toward regulation," TIEC said of a capacity market.

"A capacity market is not a real 'market.' Instead, capacity markets create a fictional product for which there is no natural demand, and then create a 'market' around the mandate to purchase this product, relying on taxes and penalties to enforce a government-created obligation," TIEC said.

"Where a true competitive energy market relies on natural market signals and dynamics to induce appropriate behavior, capacity markets must attempt to recreate these incentives through cumbersome government regulations, which are costly, inefficient, administratively complex and historically ineffective," TIEC added.

"In addition, capacity markets have been shown to be ineffective in stimulating the construction of new generation. Studies show that the overwhelming majority of capacity payments in forward capacity markets go to existing generators. A recent study analyzing the practical operation of capacity markets concluded that the PJM capacity market has resulted in approximately than 90% of the capacity payments since the market's inception flowing to existing generators," TIEC said.

"As another 2010 study on PJM's Reliability Pricing Model (RPM) [capacity market] concisely put it, '[a]fter seven auctions, and billions of dollars of costs ... significant fundamental questions remain unanswered about RPM: How can a market that funnels 94% or more of the revenue to existing generation be the best means to foster continued growth of demand-side resources and attract other new resources?' In a PJM-style capacity market, plants receive capacity payments for simply existing, regardless of their performance. This means that a 50-year old, high heat-rate plant with a high incidence of startup failure will be valued the same as a new, reliable, efficient plant. This design does not align profits with performance, forestalls replacement of older, less-efficient units, and promotes neither reliability nor high-quality generation service," TIEC said.

TIEC is one of the few stakeholders who is protesting capacity markets as a bad deal for Texans, as generators and other self-interested parties are pushing for this billion-dollar addition to Texas electric bills.  Texas customers need to make themselves heard at the PUC (Docket 40000) that a capacity market would cost them too much money, and make Texas businesses uncompetitive with neighboring states where customers are not burdened with capacity payments to generators.