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Capacity Markets: A Bridge to Recovery?

A review of the ongoing evolution of market design.

Fortnightly Magazine - May 2005

LICAP, ICAP, UCAP, NoCAP. Some markets have them, some don't. Where they do exist, no two are equal.

California was built without one, as were the markets of Australia and New Zealand. Northeastern U.S. markets all have them, albeit in slightly different variations. MISO will start one of the biggest energy markets in the world without one. PJM, long considered the model market, is debating a major overhaul to its current scheme. Others are considering such changes as well.

As the experimentation with wholesale energy market deregulation continues, an evolutionary trend in capacity market design is becoming apparent in the United States. Most critics now support the conclusion that energy only schemes in price-capped markets do not provide sufficient revenues to induce new generation and keep system-critical, high-cost generation resources in the market. As such, it is likely only a matter of time before energy only markets are extinct.

Figure 1 - Capacity Market Evolution

But, while it appears that capacity markets are here to stay, there is little consensus regarding the best design. Markets in the United States are in a state of flux, with debate raging over many different capacity market pricing schemes. The pool-wide, single-price capacity market model utilized by PJM and others now appears too simplistic. New designs are calling for ever-more complicated structures aimed at fine-tuning the location, the timing, and the type of generation resources that capacity markets induce.

While the winning recipe has yet to be selected, it is likely that participants in certain markets will witness significant changes. In certain load pockets, generators could see a meaningful increase in gross margins if a pricing scheme that compensates generators based on location is adopted. Flexible units may receive an additional bump if changes being considered in PJM are adopted. But, these shifts are likely only to persist in the short to medium term. While providing a much needed bridge to market recovery for some, if the markets function properly, price differentials should dissipate over time and bring long-term pricing back to the mean.

Background

Capacity markets are designed to ensure resource adequacy. While various definitions exist, resource adequacy generally refers to the sufficiency of generation resources to meet the peak energy needs and maintain the stability of an electric system.

In a traditional, regulated utility world, generation plants are added after resource planners determine the amount of new capacity that will be needed over the coming years to meet demand. While they are determining the actual amount of total installed capacity necessary to ensure resource adequacy, resource planners also attempt to optimize the type of capacity that is built in terms of fuel type, technology, and market segment ( i.e., baseload, intermediate and peaking). In this way, the best generation mix necessary to meet peak demand is determined through a central planning process.

In a deregulated world, the decision to build new capacity is

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