After years of concern that Ontario would not have enough electricity, the province has increased generation capacity and now has the problem of periodically having too much electricity. The best way to solve this problem is, perhaps counterintuitively, to pay producers to stop generating.
In many hours so far in 2011, particularly during periods of high wind production and low demand, wholesale buyers were paid to take electricity, but the result has been higher costs for Ontario consumers.
In a normal market, suppliers would not produce power when there is little demand because the price is too low to cover costs. However, much electricity production in Ontario is unresponsive to hourly prices.
The reason that some producers do not respond to market price signals is that many generators — especially wind and several natural gas-fired generators — are guaranteed fixed payments per kilowatt-hour generated.
The combination of a number of factors — low demand, demand that is not price responsive, increased supply of intermittent wind power, and electricity producers who have no incentive to respond to market prices — will result in periodic gluts of electricity over the coming years and higher costs for Ontario consumers
To deal with temporary oversupply, we recommend paying the generators who operate under existing fixed-price contracts to reduce output, when doing so would save money for the system as a whole.
When producers’ contracts allow them to sell electricity into the system at a price higher than the market value, consumers lose. Consumers — and some producers, if their costs of production can be avoided — could be better off if generators were paid not to produce electricity.
The premise of our recommendation is that market incentives would make existing producers more flexible, at the least possible cost. Market incentives to reduce production could manage the system with reduced costs to Ontario consumers, as compared with doing nothing or ordering producers to reduce output.
Each generator that reduced production would face different financial consequences, but market incentives could help reveal these costs. Paying the producers who can reduce output at the greatest saving could reduce costs to Ontario consumers and increase profits for those producers most willing to be flexible: a win-win solution.
We suggest creating a market in which, at times of excess electricity generation, fixed-price generators would be offered payments to reduce their output, with the amount offered being less than the cost to the system of accepting their power at the contract price.
This market would identify those producers most willing to suspend production. If some producers were able to save on fuel or other input costs or reduce wear and tear on machines, these producers might be willing to accept a payment to not feed electricity into the system.
Creating such a market will involve costs and take time. The Independent Electricity System Operator should estimate these costs, compare them to the potential savings of reduced surplus baseload generation, and determine whether foreseeable surplus baseload will be resolved before this market can be created.
Why does it make sense to pay someone not to produce? Imagine a sports team that has signed a pricey long-term contract with a star player. As the player ages, he may no longer be the best fit. With other, more productive players ready to play, and scarce roster space filled by the former star, it makes sense to trade the star — perhaps for nothing, or even to pay a continuing share of the player’s salary.
But in sports or electricity, the problem is not age, but long-term contracts that do not reward performance.
While paying generators to reduce output is a short-term solution to oversupply, there remains the question of long-term solutions as contracts expire. The answer is that the province needs to increase its reliance on pay-for-performance electricity supply contracts. This would encourage electricity producers to generate when the hourly price exceeds their cost of producing and to reduce output when the hourly price is less.
While having too much electricity may seem a less urgent problem than too little, the result is higher costs for Ontario consumers because of the pricey contracts current and past governments have signed with electricity producers. Like a general manager rebuilding a sports team, it is time to find ways to reduce our losses on these deals.
Benjamin Dachis is a Policy Analyst at the C.D. Howe Institute and Don Dewees is Professor of Law and Economics at the University of Toronto. Their C.D. Howe Institute Study “Plugging into Savings: A New Incentive-Based Market Can Address Ontario’s Power-Surplus Problem” is available at www.cdhowe.org.