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Capacity Markets: A Bridge to Recovery?

A review of the ongoing evolution of market design.

Fortnightly Magazine - May 2005

in winter, regions have seen shortages and price spikes when gas-fired generators sold gas into the heating market rather then generating electricity. In addition, many of the units have similar operating characteristics. Many believe that capacity markets need to have the ability to recognize fuel and operating diversity to avoid dependency on one fuel type and to maintain a fleet of resources that is capable of meeting all of the needs of the system operator in terms of ability to start quickly and follow load.

Demand Curve. Finally, there has been one other major shortcoming observed in capacity market design that occurs on the demand side of the equation, as opposed to the supply side issues like those already discussed. Most markets have utilized what is referred to as a "vertical demand curve" to date. This term refers to the construction of most markets where demand is set equal to the target reserve margin which, in effect, creates a fixed quantity that is completely price insensitive.

While a description of the full dynamic of the pricing structures of demand curves are beyond the scope of this article, the vertical demand curve typically has created very volatile pricing. Historical pricing patterns in existing capacity markets have tended to be shaped by boom/bust or floor/ceiling behavior where prices hover near zero when the market is oversupplied and jump to the capped price or deficiency level when the market passes through equilibrium and enters a period of shortage. This binary pricing pattern produces unwanted volatility that reduces the predictability of revenues for suppliers. Reduced predictability undermines new entrant planning or forces builders to raise costs by including a premium to cover this price risk.

Capacity Market Evolution

In response to these perceived shortcomings, many markets are considering, or already are undergoing, massive overhauls. Some are adding capacity markets for the first time, while others are adding new features to existing markets. These overhauls are spurring a new round of thinking on capacity market design that appears to be leading to interesting-and increasingly complex-new designs. While the final direction of the markets remains to be seen, what is becoming apparent is a natural evolution in capacity market form and function.

The bottom of the evolutionary ladder ( see Figure 1 ) can be defined as beginning with NoCAP markets as seen in California and ERCOT. Given the issues associated with price caps in most markets, this structure appears to be insufficient. From there we move up the evolutionary scale to simple, pool-wide capacity markets like the current form of the PJM installed (ICAP), or unforced (UCAP), market. But, as discussed above, this relatively simple structure addresses the question of volume only.

The locational ICAP market (LICAP) structure that follows the relatively simplistic ICAP/UCAP model adds a locational component to the pricing structure to add criteria for determining where in the pool new resources are constructed. The proposed system in New England, as well as the current system in New York, are examples of this LICAP approach.

In addition to addressing location, the LICAP phase also has