Big price increase behind Duquesne Light's decision to leave PJM

As a result of a recent auction of electricity, Duquesne Light will pay upwards of 300 percent more for some of its electrons in 2010 and 2011 than it is paying now.

That increase, the company says, lies behind its decision to withdraw from PJM Interconnection, the agency that manages the electricity grid in 13 northeastern and Mid-Atlantic states, and to become a member of Midwest ISO, a grid operator based in Carmel, Ind., a suburb of Indianapolis, effective May 31.

Since April, PJM has conducted a series of "capacity auctions," which set prices in advance for electricity to be held in reserve for occasions when a utility's regular supply of juice isn't enough. In the first auction, a capacity price of $40 per megawatt was set for the 2007 delivery year, which runs from June 1, 2007 through May 31, 2008. A July auction produced a price of $120 per megawatt for the 2008-09 year, and in an October auction, the price settled at $105 per megawatt for the 2009-2010 year.

On Feb. 1, the price for the 2010-2011 year was set at $174 per megawatt.

What lies behind the increase is something that PJM calls its "reliability pricing model" -- a method of setting prices that should help to insure the reliability of the grid.

It works something like this: First, PJM calculates how much reserve capacity it believes a particular utility will need during a delivery year (June 1 to May 31), say, 400 megawatts. Then PJM turns to its pool of providers and asks for bids -- or offers of capacity at a set price. The first offer, from power plant A, might be for 200 megawatts at $50 per megawatt. Power plant B might offer an additional 150 megawatts for $75 per megawatt. The utility still needs another 50 megawatts, so the bidding continues, and power plant C offers that final 50 megawatts of capacity at $100 per megawatt.

The final bidder sets the price for all bidders. So, in our example, all three providers would receive $100 per megawatt, even though the first two offered to sell for less. And because the auction is for capacity, if the utility were to use only 350 megawatts, the owner of power plant C would be paid without ever providing electricity.

Duquesne Light President and Chief Executive Officer Morgan K. O'Brien said that after the July auction, company leadership met with PJM and said, "we have a problem with this."

"We sat there and said, 'What are our rights? Why isn't everybody upset over this? This is a lot of money,' " he said.

PJM spokesman Ray Dotter said the pricing model is not that different from how pricing works in other areas.

"That's the way just about every commodity market in the world operates," he said. "It's the most efficient way to set prices."

He also pointed out that the auction is optional.

"Each utility can acquire capacity their own way," he said. "Much of the capacity acquired is not acquired through the auction, but may be negotiated separately through contracts."

"It's your choice as a participant" whether to obtain capacity entirely through contracts, through a blend of contracts and auction, or entirely through the auctions.

"It depends on how you want to manage your risk."

In fact, part of the purpose of the auctions is to encourage electricity buyers not to use them.

"The intention is to encourage buyers of capacity to enter into long-term agreements," he said, "because having the long-term price helps to encourage new resources to be built." In other words, electricity generation companies are more likely to build new plants if they expect long-term contracts to help pay for them.

Mr. O'Brien said that scenario is too vague to justify the prices that the auctions have produced.

"There's no guarantee anybody's going to build power plants," he said. "None of them are obligated to build new plants, to shut down their old plants and replace them with new technology. It's sort of a hope that if we pay you enough you're going to replace them with something new."

None of that will be the case with Midwest ISO.

"We don't have a capacity construct at this point," said spokesman Carl Dombek. Nor does the central states grid manager have plans for developing a structure for managing reserve capacity.

"We're a bit different that way," he said.

That difference concerns David Hughes, executive director of Citizen Power.

Mr. Hughes worries about Midwest ISO's reliability, with no "resource adequacy obligation" in place. Recalling the great blackout of August 2004, he said, "the report on that blackout showed a pretty chaotic reaction when the lights went out on the part of the Midwest ISO."

His group filed a petition with the state Public Utility Commission asking the agency to investigate Duquesne Light's withdrawal from PJM.

The move has received conditional approval from the Federal Energy Regulatory Commission, but Mr. Hughes said the agency "doesn't take a look at all the various aspects that impact residential customers at all.

"FERC is only dealing with the wholesale market. It remains to be seen whether this move will be good for the customers."

The PUC should make that determination, he said. But in an initial decision rendered Dec. 18, PUC administrative law judge Susan D. Colwell ruled that the agency lacks the jurisdiction to make Duquesne Light remain within PJM.

"I think it's a dodge," Mr. Hughes said. While FERC may have the last word on electricity wholesaling, the PUC "can certainly assert their authority on the impact this will have on the retail customers in Pennsylvania."