PJM Asks of FERC: Abandon Basic Economic Principles

November 9, 2017/ Jennifer Chen / Conservation, Europe, Natural Resources Defense Fund, Resources

Published by the Natural Resources Defense Fund

In its recent comments at FERC on the DOE proposal, PJM floated an idea that would inflate electricity market prices, particularly for large, inflexible, coal and nuclear power plants at times when they are least needed but can’t turn down their output. If PJM has its way, it will fast track a sweeping change to its market rules without real input from stakeholders. Generators benefiting from this proposal have chimed in with their hired “experts” in support of the idea and have conveyed to their shareholders the profits they’d reap and how they would push very hard to get the changes quickly implemented.

But a group of PhD economists whose role is to ensure the integrity of the electricity markets—the market monitors overseeing FERC-regulated markets in the Mid-Atlantic, Midwest, parts of the Great Plains, and New England states, as well as California and New York—uniformly and vehemently oppose PJM’s idea. PJM’s detailed proposal is scheduled for release on December 7. Here are some reviews of PJM’s initial concept so far:

“[H]ighly inefficient and destructive to existing energy markets in the Eastern Interconnection”

and

“[I]nconsistent with the economic fundamentals underlying efficient [spot] markets and would critically undermine the pricing and dispatch of the wholesale electricity markets”

—Market monitor for Midwest, New York, New England

“A broad adoption of [PJM’s proposal] would undermine the PJM market’s fundamental focus on achieving the competitive market result”

—Market monitor for Midwest and Mid-Atlantic

“Under PJM’s proposal, [market prices] will no longer reflect the optimal prices at which both buyers and sellers want to consume and supply the quantities of goods”

—Market monitor for California

Map of FERC-regulated markets (with the exception of ERCOT) run by regional grid operators

Source: The Federal Energy Regulatory Commission.

What is PJM’s rotten tomato of an idea?

PJM’s proposal will enable large, inflexible coal and nuclear power plants unable to lower their energy output below a certain minimum threshold to be able to fold in “fixed costs” into their market bids. While this sounds innocuous, the idea violently conflicts with the most fundamental conclusions of economic theory: that competitive markets achieve the efficient result when suppliers offer their goods at their marginal cost (the incremental cost incurred to produce additional output). In other words, by charging the marginal price to consumers and paying that price to suppliers, everyone is motivated to produce and consume goods efficiently.

Grid operators decide which resources to dispatch to meet electricity demand every 5 to 15 minutes at every location on the grid. Flexible resources can alter electricity output during these short time frames to match demand.

But large, inflexible power plants may need days to start up (i.e., a much longer time horizon than 5 to 15 minutes). These power plants also cannot run under a minimum energy output threshold, even if consumers demand less than that threshold. The costs associated with start-up and minimum generation levels are therefore “fixed costs” and are not marginal for providing additional energy. Only the power plants’ costs of supplying additional energy above their thresholds can be marginal.

(And lest you fret for the poor old, inefficient, lumbering coal and nuclear power plants, they do receive separate “out-of”market” payments for these “fixed costs.”)

PJM’s proposal abandons this fundamental economic principle by departing from using marginal costs to set market prices. No one has done this before, and no one fully understands the consequences (which weighs in favor of not fast-tracking the proposal). Some preliminary concerns are as follows.

PJM’s proposal could inflate electricity prices for consumers

PJM’s market monitor estimates that PJM’s energy market prices could go up by around 15 percent. That translates to roughly $3 billion dollars per year. The market monitor for MISO estimated how PJM’s proposal would have impacted that region’s prices over the course of the past year, and showed that its energy market prices would have increased by roughly 30 percent.

PJM’s proposal could mute market signals to flexible resources

PJM’s proposal would include “fixed costs” of power plants in market prices even at times when demand is below the plants’ minimum electricity output. Effectively, this would establish a price floor at an averaged-out level for the power plant, even when there is too much supply on the system and efficient prices would be very low or even negative. Setting a price floor masks the signals to flexible resources that the market would normally convey via prices. For example, low or negative prices can signal energy storage, electric vehicles, and grid-connected water heaters to charge, alleviating demand from these devices when the grid is stressed and electricity use is at its peak.

Source: Potomac Economics. While the real market prices (in blue) can go up and down as demand increases and decreases, the PJM pricing proposal may operate to reset the low-price valleys (typically occurring at night) to the horizontal line representing an averaged-out cost of the large inflexible power plant. The new price would follow the red dash over the course of the day.

PJM’s proposal would create market gaming concerns

Because PJM’s proposal creates prices that do not represent actual marginal costs, it also creates incentives for suppliers to deviate from their optimal level of energy production and to offer prices that do not represent their true costs. Depending on the proposal’s details, it could incent suppliers to overbid their fixed costs and underbid their marginal costs to maximize revenue for themselves without providing anything different for consumers.

Economic theory does not support PJM’s proposal

PJM attempts to invoke academic research to support its idea, but the theory it names, “Convex Hull Pricing,” is not a widely accepted economic concept. If done right, it is supposed to reduce certain (but not all) out-of-market payments to suppliers. And reducing out-of-market payments is not accepted as the overarching goal of market pricing methods. Convex Hull Pricing is also very difficult to fully and properly implement giving current computational abilities.

The efficient solution to the problem posed by inflexible power plants that can’t offer below a minimum threshold is actually well-known to economists. In 1946, the Nobel prize-winning economist Ronald H. Coase determined that when average costs decrease with output (as it does with the power plants in question), efficient pricing would result from setting the per unit price equal to its marginal cost and paying a separate amount to make the supplier whole for any costs not recovered through marginal cost pricing. This is what grid operators do today.

We submitted comments to oppose PJM’s pricing idea along with consumers and state commissions, renewables and other clean energy interests, as well as with other environmental groups.