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On the heels of the much ballyhooed California market manipulation crisis, the ISOs are now addressing the problem of localized market dominance. The issue is a real one, but the easy solutions may carry their own concerns. In all cases, the market power "flag" for the ISOs appears to be that prices should be higher during a period of shortage than in a period of excess supply.

The problem here is that a region may have a very small number of assets owned by a few market participants that have the ability, through rational economic behavior, to set the market price at a level above a "reasonable" level. The issue becomes how best to manage that situation. The preferred solution offered up is for the ISO to step in and somehow manage the price behavior in the region. This is a major shift in the role of the ISO. In the past, the ISO has acted as market manager, creating consensus among the market participants to allow "self-regulatory" activity by the market participants. The new role shifts the ISO from market manager to market participant.

All regulatory schemas control the ability of the asset owner to extract "unreasonable" returns by forcing the asset owner to negotiate directly with the regulator. The regulator thereby becomes the monopoly buyer for the market and the asset owner has no choice but to sell to the regulator at their price. Negotiation between the two sides normally sets constraints on the regulator's ability to exercise its own monopoly power. The basic premise for open markets is that the price signals set by all market participants create the "pull" for new investment and the allocation of investment capital. The reentry of the market manager into the market - as a monopoly buyer - seemingly acknowledges the inability of the market structure to perform its function. So what solutions are available?

First, all localized price caps should be created with an explicit "sunset" date for the price cap. The sunset date should be set based on the longest lead-time solution available for relieving the market power cause. This means that the system operator has to act in a distorting manner for the shortest manageable time period that allows all potential solutions to be explored. Volatility managers vastly prefer open-market solutions. Here's our modest solution: Those firms causing the problem should pay for distortions of the marketplace. Solutions distorting the role of the market manager should be avoided or minimized at all costs. Therefore, how do we avoid that result?

First, all localized price caps should be created with an explicit "sunset" date for the price cap. The sunset date should be based on the longest lead-time solution available for relieving the market power cause. This means that the system operator has to act in a distorting manner for the shortest manageable time period.

Second, the customers in the capped zone and all those along the path of potential transmission solutions should be notified of the sunset. The ISO should also note that if a market power solution by transmission is sited and permitted, but then prevented from implementation, the buses within the region where the transmission would have been built would be shifted into the same pricing region as the region where the market power situation occurs.

This is key. In this manner, the external costs of blocking efficient investment would be spread among those affected and those causing the problem. This would create an incentive for all parties to arrive at a solution that either reduces or equitably shares the total societal cost of the constraint on investment. The blocking parties must then recognize that failure to compromise and reach some solution will create a direct economic cost to them. It means that wealthy communities may pay economic incentives to lower wealth communities to allow construction of facilities.

Is this "fair?" Possibly not. However, open markets are about efficient allocation of capital, not about fairness. Politically unpalatable? Maybe. But that never stopped regulators or markets from evolving to where we are today. This solution creates a rational construct for comparing other solutions. One of the problems facing the electricity market is that the costs of inefficient resource allocations are not visible to those causing the problem. This solution should be compared to other proposals as a benchmark for decision-making.

This article first appeared in The Desk newsletter.