Capacity markets

What Is a Capacity Market?

A capacity market is a structured framework within the broader electricity markets that aims to ensure long-term grid reliability by procuring sufficient future electricity supply. Unlike traditional energy markets, which pay for electricity that is generated and consumed in real-time, a capacity market pays power suppliers for their commitment to be available to produce electricity when needed, often years in advance. This payment helps cover the fixed costs of maintaining existing power plants and incentivizes investment in new generation capacity or demand response resources²², ²³. Capacity markets are a key component of energy economics in regions with organized wholesale electricity markets.

History and Origin

The concept of capacity markets emerged from the need to address concerns about resource adequacy in restructured electricity markets. As the electricity sector underwent deregulation, separating generation from transmission and distribution, fears arose that reliance solely on spot energy markets might not provide adequate economic incentives for long-term investment in generation capacity. Power plants, particularly those with high upfront costs, need revenue certainty beyond hourly energy sales to justify their construction and continued operation.

In the United States, independent system operators (ISOs) and regional transmission organizations (RTOs) began implementing centralized capacity markets in the early 2000s to address this issue. For instance, ISO New England introduced its Forward Capacity Market (FCM) to ensure that the region would have sufficient resources to meet future electricity demand²⁰, ²¹. Similarly, the PJM Interconnection, which serves a large portion of the Mid-Atlantic and Midwest, established its own capacity market to secure long-term power supplies¹⁹. These markets typically involve regular auctions where electricity providers bid to offer their future capacity, creating a separate revenue stream distinct from actual energy sales.

Key Takeaways

• Capacity markets pay power generators and demand resources for their commitment to provide electricity capacity in the future, typically several years ahead.
• The primary goal is to ensure resource adequacy and prevent future electricity shortages and blackouts.
• Payments from capacity markets help cover the fixed costs of power plants and incentivize new investment in generation and demand-side resources.
• These markets operate through auctions, with grid operators like PJM Interconnection and ISO New England conducting them regularly.
• Capacity markets are distinct from energy markets, which pay for the actual electricity produced and consumed.

Interpreting the Capacity Market

The results of a capacity market auction, specifically the clearing price and the amount of capacity cleared, provide crucial signals to the market. A higher clearing price generally indicates a tighter future supply outlook or higher costs for new entry, potentially signaling a need for more investment in generation or demand-side resources. Conversely, a lower price might suggest an ample supply of capacity.

Market participants, including power generators, financial investors, and regulators, interpret these signals to make decisions about new power plant construction, retirement of existing units, and policy adjustments. Grid operators use the cleared capacity to assess their future reserve margin and ensure they meet reliability standards. The capacity market's effectiveness is often judged by its ability to reliably procure sufficient resources at a reasonable cost, thereby balancing supply and demand over the long term.

Hypothetical Example

Imagine a regional electricity grid operator, PowerGrid Central, needs to secure 10,000 megawatts (MW) of reliable electricity capacity for its service area three years in the future. PowerGrid Central holds an annual capacity auction.

Several entities bid into the auction:

• MegaPower Plant: An existing natural gas plant, bids to provide 2,000 MW at $50/MW-day.
• SunVolt Solar Farm: A proposed new solar facility, bids to provide 500 MW at $60/MW-day, reflecting its higher upfront capital expenditures.
• FlexDemand Solutions: A company offering aggregated demand response from commercial buildings, bids to reduce demand by 300 MW at $45/MW-day.

PowerGrid Central accepts bids starting from the lowest price until it secures the full 10,000 MW. Let's say the final bid needed to reach the target is $55/MW-day from another provider. This $55/MW-day becomes the uniform clearing price for all accepted capacity.

In this scenario:

• MegaPower Plant receives $55/MW-day for its 2,000 MW commitment.
• SunVolt Solar Farm also receives $55/MW-day for its 500 MW, despite bidding higher. It will be able to proceed with development based on this revenue stream.
• FlexDemand Solutions receives $55/MW-day for its 300 MW of demand reduction.

This payment ensures that these resources are available to the grid when called upon during the future delivery period, complementing the revenue they might earn in the separate energy market for actual electricity generation.

Practical Applications

Capacity markets are primarily applied in organized wholesale electricity markets managed by Independent System Operators (ISOs) and Regional Transmission Organizations (RTOs) in various parts of the world, including the United States. They serve several critical functions:

• Investment Signals: They provide a long-term revenue stream for generators, which is crucial for financing new power plants, particularly those with high upfront construction costs like nuclear or large-scale natural gas facilities. This helps reduce investment risk.
• Resource Development: They incentivize the development of diverse resources, including traditional generators, renewable energy projects, and demand-side solutions, by offering a payment for their commitment to provide capacity.
• Grid Planning: The results of capacity auctions inform grid operators about the expected availability of resources years in advance, enabling better long-term planning for the transmission system and ensuring resource adequacy.
• Consumer Costs: While intended to enhance reliability, the costs of capacity payments are ultimately passed through to consumers on their electricity bills. For example, customers in the PJM Interconnection region, which covers 13 states and the District of Columbia, experienced increased costs from capacity market auctions, with total costs for the 2026/2027 delivery year hitting $16.1 billion¹⁸.

The Federal Energy Regulatory Commission (FERC) provides oversight for many of these markets, ensuring they operate fairly and efficiently¹⁶, ¹⁷.

Limitations and Criticisms

Despite their role in promoting grid reliability, capacity markets face several limitations and criticisms:

• Potential for Over-Procurement: Critics argue that capacity markets can sometimes lead to the procurement of excess capacity beyond what is strictly necessary, driving up costs for consumers without significantly enhancing reliability. Some analyses suggest regions with capacity markets may exhibit larger reserve margins than necessary¹⁵.
• Cost Impacts: The payments made to capacity providers are ultimately borne by electricity consumers, leading to higher electricity bills. Recent PJM capacity auctions, for instance, have seen record-high prices, leading to concerns about increased costs for ratepayers¹³, ¹⁴.
• Incentive Misalignment: Some argue that capacity markets can provide disincentives for flexibility. They may prop up older, less flexible power plants by ensuring a revenue stream, even if these plants are not ideal for a grid increasingly integrating variable renewable energy sources like solar and wind¹¹, ¹².
• Market Design Complexity: The complex rules and parameters of capacity markets can be difficult to manage and adapt to evolving grid needs, such as the rapid growth of distributed energy resources and energy storage. There is ongoing debate and research into how these market designs can be improved for the future¹⁰. The Federal Energy Regulatory Commission often intervenes to adjust market rules in response to changing conditions and stakeholder complaints⁸, ⁹.
• Minimum Offer Price Rule (MOPR): A notable criticism has revolved around the Minimum Offer Price Rule (MOPR), which in some markets, like PJM, set a floor price for state-supported generation resources. This rule was intended to prevent state-subsidized resources from artificially suppressing capacity prices, but critics argued it hindered the participation of cleaner, cheaper resources and increased overall costs⁷.

Capacity Market vs. Energy Market

The distinction between a capacity market and an energy market is fundamental in electricity economics. While both aim to ensure reliable electricity supply, they do so by valuing different aspects of power generation.

In essence, the capacity market ensures that enough power plants or demand-reducing resources exist and are ready to operate when needed in the future, even if they aren't running continuously. The energy market then handles the dispatch and pricing of the actual electricity flowing through the grid moment by moment.

FAQs

What is the main purpose of a capacity market?

The main purpose of a capacity market is to ensure that there is enough electricity generation capacity available to meet future demand and maintain grid reliability, especially during peak periods⁶. It incentivizes long-term investment in power generation and demand-side resources.

How do capacity markets affect my electricity bill?

Payments made to power generators through capacity markets are typically passed on to consumers as part of their overall electricity bills. While designed to prevent blackouts and ensure future supply, these costs can contribute to higher rates⁵.

What is the difference between a capacity market and an energy market?

An energy market pays for the actual electricity consumed, operating in real-time or day-ahead. A capacity market, conversely, pays for the potential to produce electricity, ensuring resources are available years in advance to meet future demand, regardless of whether they are dispatched⁴.

Who operates capacity markets in the U.S.?

In the United States, capacity markets are primarily operated by Independent System Operators (ISOs) and Regional Transmission Organizations (RTOs), such as PJM Interconnection, ISO New England, and the New York ISO², ³. These organizations manage the wholesale electricity grid in their respective regions.

Do all electricity markets have capacity markets?

No, not all electricity markets have centralized capacity markets. Some regions, like Texas (ERCOT), operate primarily as "energy-only" markets, relying on high prices during scarcity events to incentivize investment and ensure resource adequacy¹. The choice between market designs is often a subject of debate among policymakers and market participants.