January-February 2006
Volume 64, Number 1
LICAP:
Helter
Skelter
10 Questions
Rep. Ed Markey
LICAP:
Helter Skelter
By Scott Strauss, Mark Hegedus & Melinda Claybaugh
Scores of attorneys and expert consultants have spent much of the past year in
FERC hearing rooms and, more recently,
congressional offices, fighting over the
need for and contours of a proposed “locational” installed capacity market for New
England known as “LICAP.” Proposed by
New England’s Independent System Operator, LICAP is less a market and more an
administrative device for funneling huge
amounts of money–estimated to be on the
order of $3 billion per year from the pockets of New England consumers to the bank
accounts of the region’s generators.
While the outcome will obviously have a
major impact in New England, public
power utilities across the nation need to be
aware of developments in this case. The
guts of the LICAP mechanism--an administratively defined, downward sloping
“demand curve”--is gaining support elsewhere. PJM’s recently filed “Reliability
Pricing Model” is likewise a demand curve
based capacity market, though with a significantly different market design from that
proposed in New England. Similarly, the
California Public Utility Commission’s Energy Division issued a report last August
recommending that the state adopt a LICAP-style demand curve. The New York
ISO already has one.
One critique of New England’s current
capacity market is that it has a vertical demand curve: when the market is a little
long, prices drop close to zero; when the
market is a little short, prices spike to the
price cap. To remedy these wide swings,
LICAP pricing relies on a demand curve
that slopes gently, at least compared to
the current vertical demand curve, to
provide predictability to LICAP prices
and reduce pricing volatility. As supply
increases relative to demand, LICAP
prices fall. When supply decreases relative to demand, prices rise.
No promise of new plants—Unlike the
current New England capacity market, LICAP adds a locational element, much like
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LMPs in energy markets, to allow prices
to vary based upon
the supply/demand
balance in various
ISO-NE regions. The
theory is that if the
LICAP price is
higher in a constrained area, it will
send a price signal to
build generation
there or transmission
to bring generation
into the area. However, this locational
element builds in an
incentive for those who benefit from high
prices to refrain from adding more generation or to oppose new generation or
transmission construction. Thus, one concern is that LICAP payments will do little
to encourage new construction, but instead
provide an unwarranted, multi-billion-dollar windfall to the region’s generators.
The proposed demand curve comprises
several parameters. The cost of a new
peaking unit determines the height of the
demand curve. The slope is based, in part,
on a target amount of capacity that LICAP
should cause to be built. When LICAP
prices are in equilibrium, the target should
produce just enough revenues to recover a
new peaker’s fixed costs.
LICAP’s capacity target is one of its
most controversial elements. New England
historically planned to have enough installed capacity to ensure that blackouts
attributable to inadequate supply (as opposed to a downed transmission line, for
example) occurred no more than once
every 10 years. ISO claims that planning to
the historical standard is not good enough
and proposes that LICAP’s capacity target
be set 5 percent higher than necessary to
meet the once in 10 years standard. In effect, ISO would force loads to purchase
more generation than needed to ensure
adequate supply and would cause the Federal Energy Regulatory Commission to
establish installed generation requirements, a domain traditionally handled by
the states.
No opt out provision—Other LICAP elements are equally troubling. All load must
buy LICAP. A municipal utility cannot “opt
out” and simply rely on its owned or contracted generation to satisfy its capacity
obligation. Instead, it must bid the generation into the LICAP market and pay the
LICAP price based upon its loads. In theory, the price paid by the municipal load
and to its generation should be the same,
thus providing a hedge. In practice, LICAP’s tests for generator performance
could make this an imperfect hedge, exposing consumers to higher costs.
LICAP’s locational aspect could also
de-value municipal generation. Consumers pay the LICAP price in the region
where their load is located, while the
price paid to generation is based upon its
location. If municipal load is in a constrained, high-priced region and its
generation is located in a low-priced region, the municipal system will not have
an adequate price hedge unless it receives
sufficient “capacity transfer rights” or
“CTRs,” which are the LICAP equivalent
JANUARY-FEBRUARY 2006 17
LICAP Helter Skelter
of financial transmission rights (FTRs).
Market power problem—Because all
load must purchase LICAP, there is little
demand elasticity, meaning that a small
reduction in supply can produce a significant jump in price. Combined with the
relatively small regions designated as part
of its locational aspect, which reduces the
number of competitors in a region, LICAP poses significant market power
exercise risks.
Part of the impetus for LICAP is the
assertion that generators do not have the
opportunity to earn adequate revenues
because energy market mitigation, particularly the $1,000 per MWh bid cap under
ISO-NE’s market rules, is said to prevent
energy prices from spiking to the levels
required for generation, especially peakers, to recover fixed costs. LICAP
“restores” these lost revenues. However,
there has been no showing that generators across the board face revenue
deficiencies or that low revenues are not
simply the result of excess supply.
Even more fundamentally, generators
have no obligation under the LICAP
mechanism to invest the billions of dollars received to build generation or
transmission in New England. They can
use the money to pay large bonuses to
management or to build plants in other
parts of the country or the world.
While not complete, LICAP’s journey
through the administrative process has
been nothing short of remarkable. Much of
the ISO’s original proposal, submitted in
March 2004, was rewritten or revised over
the course of the discovery, testimony and
trial phases of the proceeding. However,
the six-week long trial that ensued was only
the beginning.
A firestorm erupted after the issuance,
in mid June, of an initial decision largely
approving the ISO’s LICAP proposal, and
the subsequent publication of a news story
describing the multi-billion-dollar consumer cost impacts that would be
associated with LICAP implementation.
The reaction from the New England congressional delegation was swift and
substantial, as virtually the entire delegation signed a lengthy letter expressing
outrage over the judge’s decision.
Congressional reaction did not end
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with the delegation letter. Joseph Kelliher, a former House energy committee
staffer who became FERC chairman at
the end of June, made clear that he
would work to improve previously
strained relations between the commission and Congress. The Energy Policy
Act of 2005 established a litmus test of
this commitment with its provision recognizing the New England governors’
concerns about LICAP and declaring
“the sense of Congress that the Federal
Energy Regulatory Commission should
carefully consider the states’ objections.”
Two days after the new energy law was
signed, the commission granted an earlier
request by the states for an oral argument
on the initial decision and announced
that if LICAP were adopted, it would not
be implemented before Oct. 1, 2006.
This was a remarkable turn of events, as
the commission had previously and repeatedly stated that a LICAP mechanism
must be up and running by Jan. 1, 2006
and had barred consideration of any alternatives to LICAP.
The day-long LICAP oral argument
took place Sept. 20 with all commissioners
present. The first half of the day was devoted to the ISO’s LICAP proposal and
criticisms of it; the second half focused on
potential alternative mechanisms. LICAP
opponents, including many state agency
representatives, presented a forward procurement model as a potential alternative.
Under this approach, generators would be
paid in return for a commitment to have
capacity available at a defined time period
in the future. The approach’s benefit is that
it holds out the possibility that consumers’
payments will actually result in construction of needed capacity. LICAP
proponents did not object to consideration
of a forward procurement model, but
claimed that time is of the essence and that
LICAP should at least be put in place at
the beginning of 2006 as a transition mechanism or until an acceptable alternative
could be developed.
As requested by the parties, the commission in late October issued an order
establishing a stakeholder settlement
process led by a commission administrative
law judge. The commission set Jan. 31,
2006 as the deadline for finding a mutually
agreeable alternative. Meanwhile, it is continuing to evaluate the initial decision in
the event settlement talks fail. Those talks
began in early November and remain both
ongoing and confidential.
Stay tuned.
Scott Strauss, Mark Hegedus and Melinda
Claybaugh are attorneys with the Washington
law firm of Spiegel & McDiarmid.
© American Public Power Association. All rights
reserved. Reprinted with permission.
JANUARY-FEBRUARY 2006 18