WHOLESALE POWER PRICES DURING THE SUMMER OF 1997 REACHED LEVELS MUCH higher than in 1996 - higher than the variable fuel costs of even the costliest units (see Figures 1 and 2). This situation has confounded many observers. Many thought, in spite of forecasts to the contrary, that markets would continue to exhibit excess capacity for years to come. They thought need for new capacity was distant and that hourly markets would not see premiums in excess of fuel costs for marginal units - the so-called "pure" capacity premium - for years to come.
The evidence is in. It indicates that regional power markets will come into balance sooner than expected - certainly faster than many regulatory authorities had thought. New rules governing capacity expansion are not in place. Power companies will remain skeptical and hesitant to move until the rules are set. This situation creates the possibility of a turbulent transition to equilibrium in power markets (see Figure 3). Specifically, average annual prices might end up higher than what one would see during a smooth transition.
Why a Capacity Premium?
In any price-based system, the capacity premium is necessary to encourage power plant supply expansion in a competitive market. Without the premium, marginal power plants need only to meet the annual peak and ensure reliable supply would not be economic. Since their variable costs would equal the power price, they would not earn enough to pay their fixed costs (e.g., non-fuel O&M). If variable costs should exceed the power price, then power plants would shut down.