Following the presidential election of 2016, the U.S. Department of Energy (DOE) sought to establish a basis for providing cost-based compensation to a subset of the nation's coal and nuclear generation units thought to be facing retirement.

The DOE argued that the "fuel security" offered by the units via on-site fuel storage was essential to supporting a more resilient power system. The proposal stood in stark contrast with current federal policy, which favors market-based mechanisms to determine the nation's mix of generating assets and other sources of supply.

While the Federal Energy Regulatory Commission (FERC) expressed reluctance toward DOE's efforts, it too had recently signaled a willingness to consider cost-based compensation over concerns of "fuel security." In fact, FERC identified "fuel security" as a key factor in its support for ISO New England's (ISO-NE) proposed cost-of-service compensation agreement for a relatively new gas-fired power plant in Boston, Massachusetts.

While concerns over the increased use of cost-based compensation mechanisms have risen to the forefront of discussions concerning the performance of U.S. wholesale electricity market design, fuel security had, until recently, been largely absent from the debate. As such, very little consideration has been given to the costs and benefits associated with incorporating fuel security constraints into the U.S. wholesale electricity system.

ISO-NE leadership

To its credit, ISO-NE has taken a leadership role in bringing forth market-based reforms intended to ensure the region a reliable supply of power.

It recently implemented a pay-for-performance as part of its forward capacity market (FCM) design, a market-based rule change intended to ensure regional reliability by compensating assets for being available to generate electricity when called upon by the system operator. Even before its new pay-for-performance market rules have been in effect for a full year, however, ISO-NE appears to be questioning the program's ability to ensure sufficient generation resources will be available to meet projected demand.

Ironically, ISO-NE now finds itself in the position of falling back on cost-of-service arrangements.

While acknowledging that its capacity pay-for-performance program has not yet achieved full implementation, ISO-NE argues that cost-based compensation is necessary to accommodate the unique fuel supply arrangements associated with the two large (~800 MW) gas-fired units located at Mystic generation station, which the owner, Exelon, is proposing to shut down as of June 1, 2022. The two units can only obtain gas from the Distrigas LNG terminal, a nearby facility that Exelon recently purchased.

Given Exelon's ownership of the LNG facility and ISO-NE's assertion regarding Exelon's stated lack of interest in operating the facility as a merchant fuel supplier, the shutdown of the generating units suggests the shutdown of the LNG facility.

While ISO-NE's tariff permits it to retain retiring resources to resolve local transmission security issues, it had not allowed retaining resources for reliability risks due to fuel security. ISO-NE, in petitioning for a waiver at FERC, argued that the loss of the generating units would diminish fuel security through potential closure of the LNG terminal, and thus threaten regional reliability.

In sum, the ISO-NE argues that the shutdowns would place greater burden on the region's gas pipeline infrastructure, which cannot replace Mystic's LNG on New England's coldest days.  

Reliability concerns

FERC's, and by extension ISO-NE's, responsibility to ensure reliable operation of the electricity system is critical, and given the magnitude of the proposed plant retirement, heightened concern is warranted.

In this instance, the Mystic station owner requested a two-year cost of service agreement (6/1/2022-5/31/2024) for the two gas-fired Mystic generating units and the total costs associated with operating the LNG facility. ISO-NE quickly acted upon the proposed cost-of-service agreement, as it sought to ensure that the generation units would not retire as of the requested date.

ISO-NE's actions, however, raise critical questions as to the future of the region's wholesale electricity market and the potential for consumers to lose the benefits that competition has brought to the power generation sector.

Will ISO-NE's FCM be rendered irrelevant if newly defined fuel security constraints undermine its efficient operation? Does the immediate reliance on a cost-of-service agreement for the Mystic station forebode a future where power generation resources will increasingly seek compensation under cost-of-service agreements?

And finally, will society be better off if reliance on wholesale market competition wanes and system operators — or government authorities — start picking electric generation plant winners and losers based on fuel security concerns?

Market-based incentives

The economic purpose of ISO-NE's FCM is to create market-based incentives that guide both power sellers and electricity consumers to make investments necessary to ensure system demand will be met. Under the rules of the market, electric system capacity resources are expected to perform during any capacity scarcity condition. The pay-for-performance design imposes financial penalties on non-performing resources.

As directed by FERC, the penalties faced by owners of the capacity resources were heightened over time, with the initial rate (June 1, 2018) being set at $2,000/MWh and then rising to $5,455/MWh as of June 1, 2024. The relatively lower penalty rates in the early period, however, have caused ISO-NE to question whether resources have sufficient incentive to contract for the fuel supply three years hence, and whether the FCM will ensure such resources will be available when called upon.

In sum, ISO-NE expresses concern that its pay-for-performance mechanism will fail to bring forth the capacity resource mixture that ensures fuel security, especially during winter months when multi-day cold snaps can occur. The validity of this concern is evidenced by ISO-NE's petitioning to permit cost-of-service for two units it considers necessary to ensure the reliability (via fuel security) of the region's wholesale electrical system.

ISO-NE could have reasonably tested its pay-for-performance market design, and if it was determined to be incapable of meeting the system's reliability requirements (including fuel security), ISO-NE could have petitioned FERC to adjust the parameters of the FCM and thereby change the incentives of capacity resources, including the two Mystic units.

Instead ISO-NE sought approval from FERC to compensate the retiring units under a cost-of-service framework. In particular, ISO-NE argued that a waiver from its existing tariff conditions was required due to "unacceptable fuel security risks" that would arise as a consequence of the units' retirement.

Cost-of-service agreement

ISO-NE's fuel-related concerns have been well-documented. Its ongoing analysis of those issues appears to have been adapted to support its request for authority to enter into a cost-of-service agreement with the Mystic station. Although FERC denied the initial waiver request, it allowed ISO-NE to file tariff provisions that would allow it to enter into a cost-of-service agreement on a short-term basis and develop a longer-term market-based approach to meet fuel security requirements.

FERC's seeming willingness to allow the adoption of the cost-of-service agreement contributes to growing concerns that ISO-operated wholesale electricity markets' ability to signal the entry and exit of resources may be undermined.

ISO market designs rely on competitively determined energy, ancillary services and capacity market prices to guide market participant decision-making. Sellers that receive out-of-market compensation to delay or avoid retirement keep their otherwise uneconomic supply in the marketplace, which puts downward pressure on market prices received by other sellers.

FERC suggested in its order that it would consider the use of capacity auction price floors, where a generating resource capacity market offer would be based on costs the resource must recover to remain in operation and, thus, minimize the impact of the retention of uneconomic capacity on capacity market prices.

ISO-NE argues against this approach.

It observes that directing otherwise uneconomic capacity required for fuel security to make non-zero price offers into the FCM, offers that may not clear the auction and be "counted", will increase costs to consumers. ISO-NE ultimately proposed submission of zero-price offers which FERC recently approved under a split decision.

Long term effects

The issue, however, is the impact over the long-run.

By counting the uneconomic capacity (i.e., the capacity makes zero-priced offers into capacity market auctions) and pushing down capacity prices relative to what they would be if the capacity retired, other capacity resources receive lower compensation, and capacity prices will not accurately signal the value of new resources that will replace the uneconomic capacity that is expected to retire.

Moreover, if the impact of lower capacity prices hastens the retirement of capacity resources that would otherwise be economic, the costs to consumers will be driven upwards, especially when these additional uneconomic resources retire. Finally, if the retiring capacity is needed to maintain system reliability, then this is evidence that the capacity market clearing prices are too low.

The objective of capacity markets is to ensure dynamic market efficiency, as capacity market prices guide long-term decision making. In this regard, ISO-NE's objection to FERC's suggestion misses the mark.

Capacity market pricing rules should not be biased over the short-run at the expense of long-run market efficiency. Moreover, proper consideration must be given to the impact on energy market prices because any time the cost-of-service resources are dispatched in the energy market, energy prices will be lower than they would have been.

This impact can be significant if the retained uneconomic resource is consuming a fuel that may be notably less expensive than the displaced resource.

Reduced prices, reduced production 

As to the case here, the Mystic generating units consume natural gas (LNG), which is generally less costly than the fuel oils the Mystic units' operations typically displace during cold winter days on which the units are expected to be needed to provide fuel security. Reduced energy prices both lower the margins earned by other resources selling into the energy market and reduce production from those resources that are displaced.

Any downward pressure on power market prices will, in turn, increase the financial pressure on capacity resources that rely solely on market revenues. While Mystic station may appear unique given its singular direct connection to the Distrigas facility, any capacity resource that can guarantee a "fuel secure" operation could, given ISO-NE's reasoning, become eligible for a cost-of-service agreement if the retirement of the resource adversely impacts fuel security.

Ironically, the downward pressure in prices increases the incentives for other capacity resources to seek cost-of-service agreements.

In fact, ISO-NE's proposed responses to the FERC's Mystic order practically guarantee this outcome. Notwithstanding the complexity and uncertainty regarding identifying resources necessary to maintain fuel security, ISO-NE outlines a clear pathway for cost-of-service compensation to resources that can be "deemed necessary" to maintain fuel security.

Impacts not considered

The full economic impact that the potential proliferation of cost-of-service agreements will have on the costs incurred by consumers is not being considered. It is important to establish an economic framework that can objectively evaluate expenditures associated with ensuring fuel security while protecting consumers from incurring unnecessary costs.

A suitable economic framework will consider not only the short-term, day-to-day and week-to-week concerns associated with being able to meet electric system reliability requirements, but also the long-term impacts of preventing the marketplace from providing innovative responses to the obsolescence of aging system resources. A proper economic analysis will consider the long-term impact of supporting the operation of uneconomic resources, including the likelihood that continued reliance on cost-of-service agreements will be necessary.

Moreover, a complete economic analysis would also assess the benefits of maintaining an uneconomic resource and evaluate whether the benefits outweigh the costs.

Periods of high capacity and high energy prices are almost certain to accompany the electric power system's transition away from fossil fuel resources toward a less carbon-intensive resource mixture. Such prices provide the appropriate incentives for a region's supply resources to plan accordingly.

At the same time, technology is helping consumers respond to pricing variations and plan consumption to minimize costs. The possibility of high prices is critical for incentivizing the adoption of new technologies.

ISOs that rely on market structures to guide investment and consumption decisions cannot avoid these challenges to system operations, as eschewing them results in reliance on out-of-market actions. Increased reliance on out-of-market actions increases investor uncertainty, which both diminishes incentives for innovation and increases opportunities for existing capacity resource owners to consider cost-of-service agreements.

Shifting risk

A key benefit of the injection of competition into the wholesale power sector in regions such as New England has been to shift the cost of the risk associated with capacity resource investment away from consumers and on to investors who are best suited to manage those costs.

At the same time, regulators have been able to step back from the costly burden of having to manage tedious and often contentious capacity resource investment decisions as well as avoid the onus of having to approve long-term contracts and their propensity for second-guessing. This reallocation of risk has, in short, allowed consumers to reap the benefits of improved transparency, increased efficiency of existing technology, and the accommodation of new technologies.

While these benefits may be hard to measure, there is no doubt that promoting a competitive market structure shields consumers from costly risks and provides continued opportunities to quickly accommodate to a low carbon future.

In short, we should be wary of short-term regulatory fixes with their potential for both short- and long-term costs without carefully assessing the value of the alleged benefits.