Capacity payments

Capacity payments are a crucial component of modern electricity markets, falling under the broader category of energy market economics. These payments are designed to ensure the long-term reliability and stability of the electric grid by providing financial incentives to power generators and other resource providers for their ability to supply electricity when needed, rather than solely for the electricity they actually produce. Capacity payments help cover the fixed costs of maintaining power plants and other infrastructure, encouraging sufficient power generation capacity to meet peak demand and maintain grid reliability. Without capacity payments, generators might struggle to recover their upfront investment incentives, especially for plants that run infrequently but are vital during periods of high demand.

History and Origin

The concept of capacity payments emerged as wholesale electricity markets transitioned from a regulated utility model to more competitive, liberalized structures. Historically, vertically integrated utilities were responsible for all aspects of electricity provision, from generation to transmission and distribution, and were guaranteed cost recovery through regulated rates. With market deregulation in the late 20th century, the focus shifted to competitive "energy-only" markets where generators were paid primarily for the electricity they produced.

However, it soon became apparent that energy-only markets might not provide sufficient revenue signals for the construction and maintenance of power plants that are critical for system reliability but do not run consistently—such as peaking plants. This led to concerns about the "missing money problem," where revenues from energy sales alone were insufficient to cover the total costs of maintaining adequate capacity, especially for resources that provide reliability services but are dispatched infrequently.

In response, Independent System Operators (ISOs) and Regional Transmission Organizations (RTOs) in various regions, including those in the United States and parts of Europe, began implementing capacity markets or similar "capacity mechanisms" to ensure resource adequacy. For instance, the PJM Interconnection, one of the largest grid operators in North America, uses a competitive auction process to procure future capacity, typically three years in advance of the delivery year. ¹², ¹³Similarly, the New York Independent System Operator (NYISO) developed its Installed Capacity (ICAP) market to promote resource adequacy and provide suppliers with a means to recover a portion of their capital investments. ⁹, ¹⁰, ¹¹These mechanisms provide a separate stream of income for being available to produce power, regardless of actual energy output, thereby addressing the incentive gap for maintaining critical infrastructure for security of supply.
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Key Takeaways

• Capacity payments compensate electricity generators for their availability to produce power, not just for the power they actually generate.
• These payments are designed to ensure sufficient generation capacity to meet peak electricity demand and maintain grid reliability.
• They help power providers cover the fixed costs of maintaining infrastructure in competitive wholesale electricity markets.
• Capacity payments address the "missing money problem" that can arise in energy-only markets.
• They are typically determined through competitive auctions organized by grid operators like ISOs and RTOs.

Formula and Calculation

While there isn't a universal single formula for capacity payments applicable across all markets, the value is typically determined through competitive auctions. The payments are often expressed as a price per unit of capacity (e.g., dollars per megawatt-day or megawatt-year).

In many markets, the total capacity payment a resource receives can be conceptualized as:

$\text{Capacity Payment} = \text{Cleared Capacity} \times \text{Capacity Clearing Price}$

Where:

• (\text{Cleared Capacity}) represents the amount of generating capacity (in megawatts, MW) that a power plant or other resource commits to make available to the system. This capacity is often determined through a competitive bidding process within a capacity market auction.
• (\text{Capacity Clearing Price}) is the price (e.g., in $/MW-day or $/MW-year) established in the auction that all cleared resources receive for their committed capacity. This price is influenced by the supply and demand dynamics within the specific capacity market auction.

For instance, the New York ISO (NYISO) determines installed capacity (ICAP) requirements based on forecasted peak load and an Installed Reserve Margin (IRM). Load Serving Entities (LSEs) must then procure this capacity, often through auctions, and the price they pay establishes the capacity payment for the generators. ⁷The auction mechanisms vary, but the fundamental principle is a payment for the commitment to be available.

Interpreting Capacity Payments

Interpreting capacity payments involves understanding their role within the broader wholesale electricity market and their implications for both generators and consumers. For generators, capacity payments provide a crucial revenue stream, especially for plants with high fixed costs that may not run frequently. This stable income stream helps ensure the financial viability of diverse generation resources, including traditional thermal plants, renewable energy sources, and demand response programs, which are essential for maintaining resource adequacy.

For consumers and regulatory bodies, the level of capacity payments reflects the cost of ensuring reliability. Higher capacity payments can indicate a tighter market, where there is less available capacity relative to demand, signaling a need for new investment in power grid infrastructure. Conversely, lower payments may suggest ample supply. Understanding these signals is vital for effective energy policy and long-term planning within the energy sector.

Hypothetical Example

Consider a hypothetical regional electricity market operating with capacity payments. Let's say "Reliable Power Co." operates a natural gas-fired peaking plant with a capacity of 100 megawatts (MW). This plant typically runs only during periods of extremely high electricity demand, such as hot summer afternoons when air conditioning use surges.

In the annual capacity auction conducted by the regional grid operator, Reliable Power Co. bids to provide its 100 MW of capacity for the upcoming delivery year. Suppose the auction clears at a capacity price of $150 per megawatt-day ($/MW-day).

Reliable Power Co.'s annual capacity payment would be calculated as:

$\text{Annual Capacity Payment} = \text{Cleared Capacity} \times \text{Capacity Clearing Price} \times \text{Number of Days in Year}$

$\text{Annual Capacity Payment} = 100 \text{ MW} \times \$150/\text{MW-day} \times 365 \text{ days/year}$

$\text{Annual Capacity Payment} = \$5,475,000$

Even if the plant only runs for a few hundred hours out of the entire year, it receives $5,475,000 for being available to generate electricity. This payment helps cover the plant's operational costs and a portion of its initial capital investment, ensuring it remains operational and ready to serve the system during critical periods, thereby contributing to the overall market stability.

Practical Applications

Capacity payments are integral to the functioning of several organized electricity markets globally. Their practical applications include:

• Resource Adequacy: They are primarily used by Independent System Operators (ISOs) and Regional Transmission Organizations (RTOs) to ensure that enough generation and demand-side resources are available to meet peak electricity demand and maintain system reliability. PJM Interconnection, for example, conducts competitive auctions to secure power supplies years in advance to ensure sufficient capacity for future peak demand.
  ⁶* Investment Signals: Capacity payments provide long-term revenue certainty for power plant owners, incentivizing investment in new power generation facilities and the continued operation of existing ones, particularly those with high capital expenditures. This helps to prevent underinvestment in generation capacity.
• Risk Management: For Load Serving Entities (utilities and retail suppliers), participating in capacity markets helps manage the risk management associated with meeting their future load obligations. They can procure the necessary capacity through auctions, reducing exposure to volatile spot energy prices during scarcity.
• Regulatory Compliance: Many regulatory frameworks require that electric utilities or LSEs demonstrate access to sufficient capacity to serve their customers, and capacity markets provide a transparent mechanism for meeting these obligations. The New York State Reliability Council, for instance, sets an Installed Reserve Margin (IRM) that NYISO's capacity market helps meet.
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Limitations and Criticisms

While capacity payments aim to solve the resource adequacy problem, they face several limitations and criticisms:

• Market Distortion: Critics argue that capacity payments can distort the market equilibrium by providing an additional revenue stream beyond what is earned from selling energy. This can suppress energy prices and disincentivize efficient operation of some plants, as they receive payments simply for being available, regardless of their actual output.
  ⁴* Cost to Consumers: The cost of capacity payments is ultimately passed on to consumers through their electricity bills. When capacity prices increase, as seen in some PJM auctions where prices jumped significantly, it can lead to higher electricity rates for consumers.
  ³* Complexity and Design Challenges: Designing an effective capacity market is complex. Issues such as setting the right demand curve, defining the "capacity product," ensuring fair participation for different technologies (e.g., intermittent renewables versus dispatchable power), and mitigating market power are constant challenges.
  ²* Inefficiency and Over-procurement: There's a risk of over-procuring capacity, leading to consumers paying for more generation than strictly necessary. Conversely, under-procurement could lead to reliability issues. Striking the right balance is difficult.
• Discrimination Against Energy-Only Assets: Some argue that capacity payments can disadvantage "energy-only" resources that rely solely on revenues from electricity sales, potentially hindering innovation or market entry for new, efficient technologies that don't fit the capacity market's design. The Federal Reserve Bank of San Francisco has published analysis on the economic implications of different approaches to capacity, highlighting the debate over whether capacity payments distort electricity markets.
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Capacity Payments vs. Energy Payments

Capacity payments and energy payments are two distinct mechanisms within electricity markets, though both contribute to the revenue of power generators. The primary difference lies in what is being compensated:

The confusion between these two terms often arises because both are components of a generator's total revenue. However, capacity payments are an additional mechanism designed to address the specific problem of ensuring sufficient long-term investment in generation infrastructure, independent of the short-term market for actual electricity consumption. They are akin to an insurance premium for grid reliability, whereas energy payments are the direct compensation for the electricity consumed.

FAQs

What is the main purpose of capacity payments?

The main purpose of capacity payments is to ensure there is enough electricity generating capacity available to meet future peak demand and maintain the reliability of the electric grid. They provide a financial incentive for power plants to exist and be ready to operate, even if they don't run frequently.

How are capacity payments determined?

Capacity payments are typically determined through competitive auctions conducted by independent grid operators, such as Regional Transmission Organizations (RTOs) or Independent System Operators (ISOs). Generators bid to offer their capacity for a future period, and the market-clearing price becomes the basis for the payment.

Do all electricity markets use capacity payments?

No, not all electricity markets use capacity payments. Some markets, known as "energy-only" markets, rely solely on energy prices to incentivize investment. However, many major organized markets, particularly in North America and parts of Europe, have implemented some form of capacity mechanism due to concerns about resource adequacy.

How do capacity payments affect consumers?

Capacity payments are a component of the wholesale cost of electricity and are ultimately passed on to consumers through their electricity bills. While they contribute to higher costs, they are intended to ensure a reliable electricity supply, preventing outages that would impose much higher economic costs.

Are capacity payments the same as energy subsidies?

Capacity payments are not the same as energy subsidies, though both involve financial transfers. Capacity payments are generally a market-based mechanism designed to compensate for the availability of generation capacity, determined through auctions. Subsidies, conversely, are typically government-provided financial aid intended to support specific energy technologies, promote certain behaviors, or lower energy costs for consumers, often outside of a direct market mechanism.