WHAT'S GOING ON IN THE PJM CAPACITY MARKET?

My inspiration for this week’s post comes from a February 4 Wall Street Journal editorial, Josh Shapiro’s Climate Self-Protection, Josh Shapiro’s Climate Self-Protection - WSJ. Josh Shapiro is the governor of Pennsylvania, and the editorial addressed a recent news release in which he announced a settlement Pennsylvania reached with the operator of the 13-state PJM Regional Transmission Organization (RTO). The settlement will lower the cap on the price of offers that can be submitted into PJM’s annual capacity auctions. This is kind of a wonky issue, and I am doing this post at least in part to see if I can write about it in an understandable way that also is interesting.

The principal theme of the Wall Street Journal editorial is that a “force-fed green transition” imposed by radical left wingers like Shapiro created the conditions that led to historically high capacity prices in last year’s PJM capacity auction. The Wall Street Journal notes that the settlement between Pennsylvania and PJM may reduce capacity prices in future years and therefore save customers money. But “it may also make electricity less reliable and costly down the road.” As is frequently the case in articles about the electric grid, the Wall Street Journal doesn’t appear to have a full understanding of the facts. As a result, although the editorial makes some good points, I think they mostly miss the mark.

First, some brief background (three paragraphs only). I have written in detail in my past posts about capacity markets and the effect of renewable resources on those markets. I know many of you have not read all of them, so I will briefly summarize how capacity markets work. If you want a more detailed description look at past posts like Explaining the Grid Part Five: RTO Capacity Markets plus a bit of history; Subsidies; and Should Solar and Wind Be Paid for Capacity?

The capacity product that is the subject of the PJM and other RTO auctions is not a physical product, but rather a contractual obligation to offer to sell electricity into the PJM energy market. PJM acquires enough capacity in its annual auctions to ensure that there is always enough electricity offered into its energy market to serve all customers, even when electricity demand is at its highest. The recent rolling blackouts in Texas during winter storm Uri, and later during summer heat waves show what can happen when you don’t have a capacity market, which the RTO in Texas does not have.

The purpose of the capacity auction that PJM and other RTOs use to acquire capacity is two-fold. First, the auction is intended to send price signals to generation owners. When there is an oversupply of generation, prices are low, signaling that older inefficient generation facilities should be retired. When supplies tighten, prices increase, signaling that there is a need to construct new generation facilities.

Second, the auction is intended to provide the “missing money” to keep needed existing generation facilities in operation. Initially, the RTO wholesale markets relied solely on real-time energy markets to provide the price signals for new generation to be constructed and for existing generation to either continue operating or retire. However, it soon appeared to many that the energy markets were not providing the revenues necessary to support an adequate amount of generation facilities. The solution was to add a new market in which RTOs could acquire capacity. This was somewhat controversial because it deviates from pure economic theory. Nevertheless, today all RTOs, except for the one in Texas, either have capacity markets or require utilities serving customers to own generation or enter into contracts to acquire capacity.

With that (hopefully) not too long or wonky explanation, what’s going on with the PJM auction? Is the Wall Street Journal correct that green policies have caused PJM capacity market prices to increase? Well maybe partly, but it’s more complicated than that.

I’m going to start with a chart showing the auction prices from the 19 capacity auctions conducted by PJM to date. Making charts is (far) outside my area of expertise, but I think this one does the trick.

As you can see, I have placed a dotted line on the chart after the first 15 auction prices to divide the chart into two time periods, for reasons I will explain in just a bit. If you look at these 15 prices, you will see that there is some variation, but perhaps except for 2004, 2009, and 2010, they are all in the same general ballpark. We won’t go into the reasons for the outliers because they are irrelevant here, but the results of the first 15 years were relatively stable. The average of these prices is $100, and the median is $110, which I think is a reasonable level to use, at least generally, to represent the price of PJM capacity in the 2004-2018 period. Another thing to note is that there is no real upward or downward trend in the auction prices. This suggests that the “force-fed green transition,” which was in its early phase in these years, had no material impact on PJM capacity prices, either up or down.

The next four auctions are very different. First, look at the years in which they were conducted. PJM’s auctions are supposed to be conducted every year in May, and the capacity product purchased does not take effect for three years. So, for example, the first capacity auction conducted in 2004 was for delivery of capacity for a 12-month period starting in June of 2007. And for the first 15 years that is what happened. PJM conducted its auction every May for delivery of capacity three years later.

But you will see that there was a gap of almost four years between the auction in 2018 and the next auction (shown in my chart as 2022A). This auction was held in January of 2022, for capacity to be delivered starting later the same year, in June. A second auction was held in June of 2022 (shown as 2022B), for delivery in June of 2023. Then no auctions were held in 2023, and two were held in 2024, the first in June for delivery starting in 2024 (2024A) and the second in August for delivery in 2025 (2024B). Thus, not only was the annual auction schedule interrupted, but the interval between the auctions and the commencement of delivery was reduced from 3 years to no more than one year and as little as a matter of days.

Why the four-year delay between the 2018 auction and the 2022 auctions? Well, I was working at FERC then and was very aware of what was happening. The short answer is we really screwed up. A very controversial issue at the time was how, if at all, PJM’s capacity auction should account for the price suppressive effect of the subsidies being given to renewable resources (see my Subsidies post). This was a divisive issue inside of FERC as well as outside. And the timing wasn’t helped by the fact that the leadership of FERC changed in 2021 when President Trump was replaced by President Biden. FERC frequently required PJM to file new proposals, and FERC then consistently rejected those proposals. Finally, a PJM proposal was accepted and an auction allowed to be conducted at the beginning of 2022 under the rules approved by the Trump appointees. (This most likely would not have happened except that FERC was too embarrassed by the possibility that they might not approve an auction before the date for the delivery of capacity purchased in that auction had passed) The remaining auctions conducted later in 2022 and in 2024 under the rules approved by the Biden appointees.

What is important for purposes of this post is that the delay was not caused by left wingers promoting a green agenda. Yes, the sticky issue that caused the delay was how, if at all, to deal with the effect of subsidies for renewable resources on capacity market prices. But this issue did not present a very complicated technical issue. Instead the delay was caused by the failure of the FERC Commissioners to reach an agreement on which path to take, not on any real difficulty in figuring out how to build a path.

Now let’s look at the prices resulting from those last four auctions. The first, conducted under the Trump appointees’ rules imposing the maximum penalty on renewable resources, resulted in the lowest price in 12 years: $50. The next two auctions, conducted under the Biden appointees’ rules that imposed no penalty on renewable resources, resulted in even lower prices: $34 in the second auction of 2022 and $29 in the first auction of 2024. These prices were lower than all but two of the previous 15 auction prices, and the three-year average price of $38 is the lowest three-year average price in the history of the PJM capacity auction. Most knowledgeable people attribute these low prices to the considerable uncertainty as to when, if ever, new auctions would be conducted and to the short periods between the auctions and the commencement of delivery. Green energy policies did not play much, if any, of a role.

The last of the four most recent auctions reversed the trend. The capacity price shot up to $270, the highest auction price ever and almost ten times as high as the previous year’s auction price. The magnitude of this increase received national attention and many commenters, including a number of Substack authors whose sites I read, claimed that this was a clear indication of the failure of RTO markets. And the magnitude of this increase almost certainly caught the attention of Pennsylvania.

In my view, this uproar was unfair. The criticisms ignored the context of the extremely low prices from the three auctions that went before. Although the price of the last auction was high, the average of the auction prices for the last four auctions was $98; less than the average price for the 15 previous auctions. I think it is more appropriate to evaluate the results of the last auction in this context. No annual auctions at all were conducted for four years. Then, when the auctions finally resumed, the next three yielded extremely low capacity prices. Viewed in this context, it is only fair to conclude that the large increase in the capacity price in the last PJM auction represented an expected, and needed, correction of the effects of the prior six years.

Putting aside whether the high prices of the last auction are a good thing or a bad thing, how accurate was the Wall Street Journal’s contention that green energy policies were responsible for the large increase? Well, this is a complicated issue and we could do a real wonky dive into the weeds here, but I will try to avoid doing that. The price increase in the last auction resulted from both a large increase in demand for capacity to be purchased from the auction and a reduction in the amount of capacity offered into the auction. Basic economic theory will tell you that either of these factors can cause an increase prices, and in combination an increase is guaranteed.

Green energy policies had very little to do with the increase in demand. Instead, that increase came from energy hungry data storage and AI technologies. The unexpected dramatic increase in electricity demand from these technologies has been featured in the news recently, so I won’t go into this in any detail. All I will say is that neither of these uses are caused by green energy policies.

But green energy policies undoubtedly do affect the supply of capacity from fossil generation and, perhaps, from nuclear reactors (some green energy supporters love nuclear and some hate it). After all, the whole point of green energy is to transition away from fossil and, perhaps, nuclear and to renewable solar and wind energy. But it is difficult to see how these policies had much of an affect on the prices in the most recent auction. The amount of nuclear capacity offered into the auctions has been relatively unchanged over the last four auctions, nor has there been a significant decline in offers from natural gas-fired generators.

In contrast to nuclear and gas, there has been a significant downward trend in coal capacity offered over the last four auctions. Considerably less coal capacity was offered into the last auction than was offered into the 2022A auction two years before. But this reduction in the amount of available coal capacity seems likely to have resulted from the very low price signals sent in the prior six year period. And in addition, the low natural gas prices made possible by fracking has rendered coal uneconomic when compared to gas. As a result, natural gas-fired generation has replaced coal-fired generation as the dominant generation technology in the US. The reduction in coal-fired generation offered into the most recent PJM auction merely reflects this trend.

I also would note that the amount of wind and solar capacity offered into the last four PJM capacity auctions has never exceeded three percent of the total capacity offered into the auction. This relatively small amount of green power perhaps could have had some effect on reducing the auction prices in the previous three auctions. But it would be a stretch to place much blame for the reduction in the amount of fossil capacity offered into the most recent PJM auction on wind and solar generation.

I think the more important concern raised by the Wall Street Journal relates to the future. The purpose of PJM’s cap on the prices that can be offered into the PJM auction is to limit the capacity price that can come out of the auction. This is because the capacity price is set by the highest accepted offer. So, for example, if there were a $100 cap on the price that can be offered into the auction, the highest price for capacity that could be set in the auction would be $100.

The settlement between Pennsylvania and PJM lowers the maximum price that can be submitted in the auction. This means, as the Wall Street Journal accurately notes, that “a lower auction price cap could result in the retirement of more fossil-fuel generators.” These retirements could occur if the lower auction price cap results in a capacity price that fails to provide the “missing money” needed by fossil generators to continue to operate. And PJM’s reliability could be threatened if too many base load generators retire before PJM has transitioned to a green power configuration that can reliably serve customers without using fossil generation. PJM is unlikely to complete such a transition for many years, if ever.

But how likely is that to happen? According to Governor Shapiro’s press release announcing the settlement, PJM agreed to lower the offer price cap from “over $500,” to $325. This is a significant reduction. But $325 is still $55 higher than the most recent PJM auction price. And this was the highest PJM auction price ever. It is over three times higher than the $100 average capacity price in the first 15 PJM auctions before the auction process was disrupted. Those prices supported the construction and operation of an adequate amount of capacity in PJM. I suspect a string of future PJM capacity prices set at $325 would continue to do so. To me, the real danger to PJM’s reliability is not the potential application of a $325 price cap, but rather an extended return to the very low price levels we saw in the prior three PJM capacity auctions.

After reviewing this post, I am afraid that perhaps it is a bit wonky. If any of you were able to make yourself read this far, I hope that it was not too much so and that you found it to be at least somewhat interesting.

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