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Capacity Markets Demystified

Emerging capacity auctions offer limited but valuable risk-management tools for asset owners.

Fortnightly Magazine - March 2008

NOTE: Ventyx Advisors is part of the Ventyx Energy Group formed by the acquisition and merger of Global Energy Decisions and New Energy Associates by Ventyx.

For much of the history of the electric power industry, power generation plants were built by utilities, paid for by ratepayers and incorporated into the utility ratebase as a result of approvals from state regulators.

The past decade has witnessed the development of a large fleet of unregulated, merchant-power generation resources in the United States (see Figure 1) . More than one-third of all generation no longer is owned under the traditional vertically integrated electric utility model, 1 and these unregulated assets face various markets and a wide range of risks. The revenue expectations for these assets often are divided into two categories: energy and capacity. These concepts frequently are used without a precise definition.

Unlike most major industries, the electric power industry has historically made a clear distinction between the value of energy produced from a power plant and the value of “capacity,” which is the ability of a power plant to generate electric energy. 2 While all industries have both units of production and the capability to produce output, when discussing value one typically looks at these concepts separately. Simply stated, one either can purchase a factory, or purchase the factory’s output. When one purchases the factory’s output, there implicitly is some value of the factory embedded in the price, but it is rare to pay a separate price for the factory’s productive capability.

In contrast, the U.S. electric power industry developed largely as a government-regulated monopoly. One of the legacies of this regulation is that energy, when valued at the wholesale level, was often valued at its variable cost of production, with no allowance for the cost of building the power plant. In order to compensate power-plant owners for their investment in generating assets, a separate “demand” or “capacity” charge was paid by customers.

Fast forward to today’s partially deregulated electric power markets. Wholesale electric energy often is traded in various central markets, as well as among individuals in bilateral transactions. Wholesale electric energy prices largely are deregulated, and clearly, over the past decade, market participants have become adept at routinely charging much more than their variable production costs. This “rent extraction,” as economists commonly call it, can take various forms, and while the mechanism for achieving it can be complicated, the evidence is quite clear that today’s wholesale electricity prices typically are higher than the variable costs of most or even all suppliers.

Even though energy prices are much higher than production costs in this competitive marketplace, the prices often are not high enough to induce investors to build new power plants. As a result, various mechanisms have evolved since the early 1990s to induce new construction (and prevent retirement of old power plants) by

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