RTO forward capacity markets are unlikely to succeed

Michael Giberson

The Gulf Coast Power Association meetings earlier this week included a debate over the future of resource adequacy within the ERCOT power system. Debate moderator Eric Schubert, BP Energy Company, introduced the issue with a critique of capacity market structures that is heavy on its reliance on Hayek’s knowledge problem. It is a topic dear to our heart here at the Knowledge Problem blog, so I thought we’d share a bit of it.

Here’s Schubert:

Hayek’s “Knowledge Problem” and its optimal solution – decentralized commercial markets – provide the best lens for regulators to see the fundamental issue in electricity market design in response to rapid technological change and increasingly diverse groups of buyers and sellers. As the procurement and use of electricity cross a complexity threshold, as a few customer classes are transformed into a multitude of individual market participants, the electricity market design needs to move away from centralized planning to a decentralized procurement of resources, to be both sustainable and efficient.

… In trying to adapt the centralized forward capacity mechanism to changing market and technological conditions, regulators and RTOs play a never-ending game of “whack-a-mole” because they can never overcome the “Knowledge Problem.” Even worse, under centralized procurement or any type of explicit “top-down” procurement of new resources mandated by regulators, unintended consequences of centralized procurements arise at the speed of markets and are corrected at the speed of administrative law.

Both long-standing economic theory and recent economic practice suggest that centralized forward capacity mechanisms are very unlikely to succeed. If they fail, state and federal regulators in the US will be forced to choose between the two known solutions to the “Knowledge Problem”:

  • A return to full integrated resource planning conducted by regulators, or
  • A move to fully decentralized wholesale and retail markets where individual customers make their own choices.

… Integrated resource planning, however, solves the “Knowledge Problem” by suppressing it. Having regulators in charge of integrating 21st century technologies would prevent consumers, retailers, and other market participants from using their local knowledge and ingenuity to find the next killer app or great idea that would provide all of us cleaner, more efficient and thoughtful use of energy. Or put another way, would we even have I-Phones today if regulators had never broken up Ma Bell?

[The alternative approach is that] with the proper price signals, buyers and sellers in ERCOT’s energy-only market will procure and manage sufficient resources to meet their individual needs and preferences while keeping the market resource adequate. Such decentralization of decision-making is the most efficient solution to the “Knowledge Problem.” The challenge of this path, however, is keeping the lights on during the transition; none of us can fully understand at this moment how the integration of the new technologies will happen, and what new ways of doing business and managing electricity use will spontaneously emerge over time.

By the way, in that first ellipsis I excised a reference to and quote from a great paper by Kenneth Rose that takes a detailed look at RTO capacity market structures.

Schubert’s full introduction is publicly available on the GCPA website, but only for the next month or so. Get it while it’s hot (and available).