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The Capacity Market Enigma

Why haven’t reliability markets developed?

Fortnightly Magazine - December 2005

competitive market forces to provide new generation supplies, we need separate, long-term, installed-capacity markets. Not only will that market reduce the risks from volatile energy markets, but it will provide a hedge against the inevitable regulatory and political pressures for energy market intervention when prices are high. New generation investment, spurred on by a separate capacity market, not only will reduce capacity market prices but will increase competition in the energy markets. The result will be lower energy prices and improved reliability.



1. Devon Power LLC, et. al., Docket No. ER03-563-030 . The case is awaiting an order by FERC. The New York Independent System Operator has overseen a similar capacity market since May 2003.

2. Generation capacity provides two separate but related products: security and adequacy. Security is the ability of the electric system to respond to instantaneous or short-term changes in demand, such as providing spinning and non-spinning reserves. Adequacy is the ability of the electric system to respond to long-term changes in demand. We are unaware of anyone who argues that system security products, such as spinning and non-spinning reserves, are not needed, or that a generation-only market would provide those products. The controversy focuses on whether a separate, long-term resource adequacy market is required.

3. Although we simply refer to price caps, modifications to operating-reserves requirements may have similar effects on generators’ revenues, as the system operator might refrain from purchasing all the required reserves (and prevent further price increases) during capacity shortages.

4. Of course, price caps aren’t the only risks facing potential generation developers. Many state regulators have become increasingly concerned about who will build new baseload generation, as continued industry restructuring, market uncertainties, and changing environmental regulations have increased risk, creating an investment climate where developers and banks want signed, long-term contracts with utilities before breaking ground, while utilities and other retail providers are reluctant to enter into long-term contracts because of the regulatory and market risks such contracts pose. Addressing those uncertainties is best left to another article.

5. The flip side of lumpy investments is the potential for market power. In California, for example, RMR contracts were used extensively during 2000 and 2001 to prevent capacity withholding in transmission-constrained regions. See Scott Harvey and William Hogan (2001), “Further Analysis of the Exercise of Market Power in the California Electricity Market.” Working paper, Center for Business and Government, John F. Kennedy School of Government, Harvard University.