Capacity market

What Is a Capacity Market?

A capacity market is a key component of electricity markets designed to ensure the long-term grid reliability and adequate electricity supply for consumers. It is an auction-based mechanism where grid operators procure commitments from power generators and other resource providers to be available to produce electricity (or reduce demand) at a future date, typically years in advance. Unlike an energy market, which pays for actual electricity generated and consumed in real time, a capacity market pays for the potential to generate electricity or reduce demand, ensuring there is always enough supply to meet peak demand and maintain system stability. Participants in a capacity market include traditional power plants, demand response programs, and energy storage facilities.

History and Origin

The concept of capacity markets emerged from challenges within deregulated wholesale electricity markets in the late 20th and early 21st centuries. In purely energy-only markets, concerns arose that prices might not be sufficient to incentivize the necessary long-term investment in new generation or the maintenance of existing power plants, particularly given the high capital costs and infrequent operation of certain types of power assets (e.g., peaking plants). This "missing money problem" could lead to insufficient capacity and an increased risk of blackouts during periods of high demand.

To address these concerns, various regions began implementing capacity mechanisms. The PJM Interconnection, which operates the electricity grid across 13 U.S. states and the District of Columbia, introduced its Reliability Pricing Model (RPM) in 2007, shifting from a short-term capacity model that had been criticized for low prices and high investor risk. PJM's capacity market was designed to proactively secure sufficient power supplies for future reliability. Similarly, in the United Kingdom, the Capacity Market (CM) was introduced in 2014 as part of the Electricity Market Reform (EMR) program to provide incentives for capacity to be on the electricity system and deliver when needed. The first UK Capacity Market auction took place in December 2014, with official results confirmed in early 2015.⁹

Key Takeaways

• A capacity market ensures the future availability of electricity generation and demand reduction resources.
• It operates through auctions, typically held years in advance, where resource providers commit to being available.
• Payments are for capacity (potential to produce), distinct from payments for energy (actual electricity produced).
• The primary goal is to enhance grid reliability and prevent resource adequacy shortfalls, especially during peak demand.
• Capacity markets aim to send price signals that encourage long-term investment in the power sector.

Interpreting the Capacity Market

Interpreting the outcomes of a capacity market involves understanding the balance of supply and demand for future power availability. The clearing price in a capacity auction indicates the cost of ensuring resource adequacy for a specific future period. A higher clearing price generally suggests a tighter supply outlook or increased anticipated demand, signaling a greater need for new investment or retention of existing capacity. Conversely, lower prices might suggest a more robust supply relative to expected demand.

The Federal Energy Regulatory Commission (FERC) plays a significant role in overseeing these markets in the United States, including reviewing and approving market design changes.⁸ Market participants and regulators closely monitor these prices and volumes to assess the adequacy of future power supplies and the effectiveness of the market design in meeting reliability goals.

Hypothetical Example

Imagine "EnergiaGrid," a hypothetical grid operator, needs to secure 100 megawatts (MW) of capacity for a delivery year three years in the future to maintain grid reliability. EnergiaGrid conducts a forward capacity auction.

Several participants submit bids:

• Solar Farm A: Offers 20 MW at $10/MW-day.
• Old Coal Plant B: Offers 40 MW at $20/MW-day (needs some upgrades to ensure availability).
• New Gas Plant C: Offers 30 MW at $30/MW-day (new construction).
• Demand Response Provider D: Offers 15 MW at $25/MW-day (for consumer load reduction).

EnergiaGrid accepts bids, starting with the lowest price, until the 100 MW target is met:

1. Solar Farm A: 20 MW accepted ($10/MW-day). Remaining needed: 80 MW.
2. Old Coal Plant B: 40 MW accepted ($20/MW-day). Remaining needed: 40 MW.
3. Demand Response Provider D: 15 MW accepted ($25/MW-day). Remaining needed: 25 MW.
4. New Gas Plant C: 25 MW accepted (from its 30 MW offer) at $30/MW-day. Remaining needed: 0 MW.

In this scenario, the auction clears at $30/MW-day, as this was the price of the marginal accepted bid. All accepted bidders (Solar Farm A, Old Coal Plant B, Demand Response Provider D, and New Gas Plant C for its cleared amount) will receive $30/MW-day for their committed capacity during the future delivery year, regardless of their individual bid price. This payment mechanism provides revenue certainty, incentivizing continued investment and maintenance by these diverse capacity providers. This cost is ultimately passed on to utilities and then to end-use consumers.

Practical Applications

Capacity markets are primarily applied in regions with deregulated or restructured electricity markets, particularly those overseen by Regional Transmission Organizations (RTOs) or Independent System Operators (ISOs) in the United States. These markets serve as a critical tool for resource adequacy, complementing energy-only markets by explicitly valuing the availability of generation and demand-side resources.

For instance, the PJM Interconnection utilizes its Reliability Pricing Model to secure adequate capacity for its region, which spans parts of 13 U.S. states and the District of Columbia.⁷ The Federal Energy Regulatory Commission (FERC) provides oversight and guidance for wholesale capacity markets in the U.S., ensuring they operate fairly and efficiently.⁶ These markets help ensure that utilities have sufficient resources to serve their customers, reducing the risk of blackouts. Furthermore, they influence investment decisions, guiding where and how much new generation or demand-side resources are needed based on future reliability requirements. The North American Electric Reliability Corporation (NERC) frequently publishes assessments highlighting the need for reliable capacity across North America, underscoring the ongoing relevance of capacity markets in addressing potential energy shortfalls amidst rising demand and plant retirements.⁵ These assessments inform the regulatory framework and market design adjustments.

Limitations and Criticisms

Despite their role in enhancing reliability, capacity markets face several criticisms. One common critique is the potential for over-procurement of capacity, which can lead to higher costs for consumers. Some analyses suggest that administratively determined demand curves in capacity markets may procure more electricity capacity than necessary to meet reliability objectives, leading to consumers paying billions of dollars extra for excess capacity.⁴

Another point of contention is the impact of state subsidies on market operations. The introduction of state-supported generation, particularly from renewable energy sources, can depress clearing prices in capacity auctions, potentially undermining the market signal for conventional power generators and creating concerns about market power. Regulators often grapple with how to integrate subsidized resources without distorting the market, sometimes implementing measures like the Minimum Offer Price Rule (MOPR) to mitigate these effects.³

Furthermore, the complexity of capacity market design, including factors like de-rating factors for intermittent resources (e.g., solar and wind) and the penalty regimes for non-performance, can pose challenges for market participants and may not always provide optimal incentives for all resource types.² Academics have debated whether capacity mechanisms address a fundamental market failure or if they inadvertently create distortions.¹ These complexities necessitate ongoing reviews and reforms to balance risk management with cost-effectiveness within the broader regulatory framework.

Capacity Market vs. Energy Market

The terms "capacity market" and "energy market" are often confused but refer to distinct, albeit complementary, components of electricity market operations. The fundamental difference lies in what is being traded and compensated.

An energy market is where actual electricity is bought and sold for immediate or near-term delivery. It functions much like a spot market, with prices fluctuating based on real-time supply and demand. Payments in the energy market are made for kilowatt-hours (kWh) of electricity physically produced and consumed. Its primary purpose is to balance the grid in real-time and provide efficient pricing for dispatchable generation.

In contrast, a capacity market pays for the availability of electricity generation or demand reduction resources at a future date, typically years in advance. It addresses the long-term adequacy of electricity supply by providing a revenue stream to power providers for their commitment to be online and capable of producing power when called upon, even if they are not actively generating at all times. Payments in a capacity market are typically based on megawatts (MW) of committed capacity. While the energy market ensures the lights stay on now, the capacity market ensures there will be enough power available in the future.

FAQs

What is the primary goal of a capacity market?

The main objective of a capacity market is to ensure long-term grid reliability by incentivizing sufficient investment in electricity generation and demand response resources to meet future peak electricity demand.

Who participates in a capacity market?

Participants typically include traditional power generators (e.g., natural gas, coal, nuclear, hydroelectric), renewable energy facilities (e.g., wind, solar), energy storage facilities, and providers of demand response and energy efficiency programs.

How do capacity markets affect consumers?

Capacity market costs are typically passed through to consumers as part of their electricity bills. While they add a charge for ensuring future reliability, the aim is to prevent potential blackouts and reduce future price volatility in the energy market, which could otherwise result from capacity shortages.

Are capacity markets regulated?

Yes, in many regions, capacity markets are heavily regulated. In the United States, the Federal Energy Regulatory Commission (FERC) oversees these markets, approving their design and rules to ensure they are just and reasonable.