Electricity Markets

Is increase in merchant generation capacity a positive?

Since 2011, the American Public Power Association has been conducting analyses of the financial arrangements behind new electric generation facilities constructed each year. In past years, the vast majority of new capacity was constructed under long-term bilateral contracts or utility or customer ownership, with almost no project developers choosing to rely on more volatile wholesale market revenues. But in 2015, that trend shifted significantly, with almost 20 percent of the new capacity constructed under merchant arrangements. (A merchant plant is one that is not owned by a utility or end-use customer, and does not have a long-term bilateral contract for the sale of the power. These plants earn their revenues entirely from the wholesale electricity markets.)

The table below provides greater detail on the distribution of new capacity constructed in 2015, according to technology and financial arrangement.

These data show a few notable trends.

  • Merchant generation accounted for 19 percent of the new capacity, compared to a little under 5 percent in 2014.
  • Wind and natural gas dominate the new generation constructed in 2015, equal to 47 and 33 percent of the new capacity respectively.
  • Almost all natural gas generation was built under utility ownership or as merchant projects, and wind is primarily funded under contracts or market sales.
  • Contracts or ownership by end-use customers amounted to 12 percent of the new capacity, compared to about 4 percent in 2014.
  • Utility ownership declined as a share of new capacity, from 42 to 20 percent.
  • At least ten percent of the new generation does not have a contract for the sale of the power, but does have in place a financial hedge to ensure a minimum stream of revenue.

Utilities were responsible for 62 percent of the new generation (about 11,000 MW) through both bilateral contracts and ownership, a decline from the 72 percent share from last year, largely due to the decline in utility ownership of new capacity. Of the total utility-sponsored generation, 69 percent was owned or contracted for by investor-owned utilities, 22 percent by public power and 5 percent by rural electric cooperatives. Public power sponsorship of new generation accounted for a greater share of new capacity than public power's share of total electricity consumption (15 percent).

The decline in utility-sponsored generation was made up for by an increase in customer ownership and contracts, comprised almost entirely of wind and solar generation. These range from direct ownership of renewable power, such as by IKEA and Apple or individual factories, to individual municipal contracts with solar farms to power schools or wastewater treatment or municipal buildings.

That a majority of generation capacity is constructed under ownership or bilateral contracts is not surprising, given that the financing of capital-intensive projects, whether a wind turbine or a natural gas combined-cycle plant, is much more feasible with a predictable stream of revenue. Does the increase in merchant financing indicate that the capacity and energy markets can be relied on to produce needed generation resources? Not necessarily. A closer examination of the recently constructed merchant generation shows a more complex picture.

Summary of Merchant Generation Constructed in 2015

With the exception of one 25-megawatt (MW) wind farm in Maine, all of the merchant generation capacity was constructed in PJM and ERCOT. In PJM, about 2,600 MW of new merchant generation was built in 2015, out of a total of 3,000 MW of new generation, or about 85 percent of the new generation within PJM. But these data are somewhat misleading as two new natural gas plants, accounting for over half of the new merchant generation constructed in PJM — the 685 MW Newark Energy Center and 700 MW Woodbridge Energy Center — were initially awarded 15-year Standard Offer Capacity Agreements (SOCAs) under the New Jersey Long Term Capacity Agreement Pilot Program (LCAPP). Because the SOCAs have been invalidated by the Supreme Court's decision in Hughes v. Talen, these plants shifted the recovery of their costs from steady long-term contract revenues to market revenue, but it is not known if these projects would have been undertaken in the absence of LCAPP. A shift from a bilateral contract to volatile market-based revenue streams entails an increase in the cost of capital for financing the plants due to the greater uncertainty of the revenue stream.

Two other merchant plants — the 110-MW Perryman 6 natural-gas plant and the 30 MW Fair Wind Energy Project — were constructed in accordance with Exelon's commitment to Maryland under the agreement on the company's merger with Constellation.

In sum, about 1,600 MW of allegedly merchant generation was built for reasons other than earning market revenues and the majority of it was planned under the expectation of long-term contracts. Netting out these four plants reduces the portion of new generation in PJM accounted for by merchant arrangements to 950 MW, or 31 percent of the new generation in PJM, which is comprised of two large natural gas plants (the Nelson Energy Center in Illinois and Garrison Energy Center in Delaware), along with several small solar and battery projects.

Removing these PJM merchant projects from the total merchant capacity constructed in 2015 reduces the percentage of new capacity accounted for by purely merchant projects to 7 percent on a national basis.

The remaining merchant projects were in ERCOT, which is the RTO covering the state of Texas. These projects included three merchant wind projects, ranging from 150 to 200 MW of capacity and a large merchant natural gas project. Many of the new wind and natural gas project in Texas, however, have also arranged for financial hedges where the developer or an entity financing the project receives a guaranteed price from a third-party financial entity. It is possible that the projects characterized as merchant therefore could have financial hedges that were not publicly announced.

In sum, the unearthing of the details on merchant generation shows that there is far less "purely merchant generation" than appears from the data alone. But it is still a trend that cannot be denied, especially in the PJM footprint.

Is an Increase in Merchant Generation a Positive Development?

While supporters of the RTO-operated markets point to the growth of merchant generation as a sign of market success, one cannot simply conclude that this trend is a positive development nor does it necessarily indicate that the electricity markets are sending the proper price signals to incent the development of needed resources. First, merchant generation development does not involve long-term planning to determine if the new generation represents an optimal mix of resources, and how the significant growth of new natural gas generation will impact natural gas prices and pipeline constraints. Second, the financing of merchant plants tends to involve a higher cost of capital as a reflection of the greater risk involved in relying on volatile markets for future revenue streams. Third, there is evidence that the completion of merchant plants is less certain than plants built under a contract or ownership. For example, the PJM market monitor projected that, based on historical completion rates, 70 percent of the merchant projects are expected to go into service, compared to 88 percent of non-merchant projects.

Along with the increase in new merchant capacity construction, a coincident trend has been the greater financial support being pledged to existing merchant nuclear plants from states to prevent the retirements of these plants. Illinois' passage of the "Future Energy Jobs" bill and the New York Public Service Commission's Clean Energy Standard order are two examples of such state actions. Other merchant owners of nuclear generation have called for additional financial support. For example, PSEG issued a paper in June, stating that "to ensure that carbon-free nuclear remains a sustainable energy source in New Jersey, lawmakers should find a way to support nuclear as a zero-emission fuel in the same way solar and other fuels are supported." This movement away from merchant funding of existing generation, especially nuclear plants, is an indicator that the organized capacity and energy markets operated by the Regional Transmission Organizations do not send the price signals needed for the combination of resources desired by policymakers.

To conclude, a shift towards more merchant generation and reliance solely on market revenues may indicate a movement away from planning and policy decisions that take into account critical factors such as fuel diversity, environmental policies, and economic development. This is not a desirable trend nor is it an indicator of successful markets. The Association continues to urge policymakers to remove any impediments to long-term contracting and ownership of resources, and allow for local utilities and state agencies to determine the best mix of electricity resource needs."