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Capacity Markets: A Bridge to Recovery?

A review of the ongoing evolution of market design.

Fortnightly Magazine - May 2005
Table 1 - Capacity Market Designs in U.S.

made by individual market participants instead of through a central planning process. The underlying question becomes how to design a market to properly incentivize profit-maximizing participants to develop enough generation capacity to ensure resource adequacy. As the theory goes, the answer is that the market must provide adequate compensation so that a new entrant is able to earn revenues that are high enough to cover costs and earn a fair return.

Two Basic Models

There are essentially two schools of thought when it comes to designing markets that provide adequate revenues to generators: energy only (referred to as "NoCAP") and energy-plus-capacity markets. 1

Many have followed the NoCAP route. In the United States, California, ERCOT, and MISO started without an explicit capacity market. Australia and New Zealand, as well as the markets in Ontario, Alberta and Scandinavia (NORDPOOL) all have functioned without a formal capacity support mechanism. The general belief (hope) in these NoCAP markets is that sufficient revenues will be earned from the energy markets (plus other ancillary services where applicable) alone to induce an adequate amount of new generation resources. The idea is that the inherent volatility of the energy markets will deliver enough high-priced hours during summer- or winter-peaking periods that a new generator would be fully compensated and earn a fair return. The logic for marginal, system-critical resources is the same: The few high-priced hours when these units are dispatched will provide enough compensation to cover going-forward costs and keep the units from retiring.

The other option, of course, is to couple a capacity market with the energy market. PJM, ISO New England, the New York ISO (NY-ISO), and others have used variants of this theme fairly successfully. Energy-plus-capacity markets generally function by compensating generators based on total installed, or available, capacity. 2 Generators receive a payment that supplements revenues earned in the other markets. The idea is that total revenues should be sufficient to cover going-forward costs at a level that is comparable to what generators earn from hourly dispatch in an energy-only market.

Bumps in the Road

As deregulated markets collect a historical record that includes the experience of a full boom-bust business cycle, several shortcomings in existing markets are becoming apparent. For NoCAP markets, it is the institution of price caps that is arguably the most notable contributor to their inability to provide a stable and sufficient revenue stream to generators. Others with capacity markets in place are finding that simply adding generic capacity resources somewhere within the market footprint may not be the optimal path to ensuring resource adequacy. What started as simply a question of how much, has re-cently matured to a question of what, where, and when.

Price Caps. In U.S. energy markets, extreme price volatility is unpalatable to the general public. As a reaction to high prices in the Midwest in 1998, PJM in 1999, and California in 2000, many markets created price ceilings (or price caps) to protect the public from extreme energy price volatility. But the problem with this type of protection is that it sacrifices the prospect of