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Higher capacity prices give PJM merchants much-needed breathing room

Merchant combined-cycle plants received project financing at the outset of the shale gas revolution in part on the belief that low natural gas prices near shale production and high cleared capacity prices would drive stable returns in PJM. However, power plants clearing at PJM's "RTO" price have found overall margins barely adequate to cover debt payments, let alone to provide adequate returns. Prior to this May's Base Residual Auction cleared capacity prices in RTO had fallen rapidly over the last three years from a high of $164.77/MW-day for the 2018/2019 reliability year to $76.53/MW-day for 2020/2021, while spark spreads in wholesale electricity markets remained weak due to flat electricity demand.

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S&P Global Market Intelligence estimated the free cash flow to service debt for a representative merchant combined-cycle plant recently placed in service in Ohio. Market Intelligence estimates the plant will require $10.50/MWh in total margins on electricity and capacity to service debt and $12.75/MWh to meet typical Debt Coverage Ratio criterion. Given settled prices for PJM RTO capacity, forward gas prices, and projected wholesale electricity prices, Market Intelligence forecasts that such a plant may struggle to earn these margins in 2019 to 2020. Moreover, under the Market Intelligence capacity price forecasts for 2021 to 2022, the situation seemed unlikely to improve, which could have prompted a call for greater loan reserves, refinancing or potential financial distress for the plant's uncontracted capacity.

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However, RTO prices cleared substantially higher than in the 2020/2021 Base Residual Auction and also higher than the Market Intelligence forecast as of March 31. The 83% year-over-year increase in the RTO price will drive substantial revenue increases to plants as well. Compared to estimated capacity revenue in the March 31 power forecast, Market Intelligence estimates the incremental capacity margin impact at $1.66/MWh in 2021 and $2.43/MWh in 2022 if 2019's auction clears at the same price. Combined with steady growth in spark spreads, forecast to grow by $0.90/MWh in 2019 to 2022, Market Intelligence projects new merchant combined-cycle gas turbine plants can achieve adequate cash flow. The need to achieve more sustainable returns may have influenced the bidding behavior of the merchant gas plant segment, helping to drive a higher clearing price.