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Capacity Markets Demystified

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

Fortnightly Magazine - March 2008

providing additional revenue to supplement the energy revenue. This supplemental revenue takes various forms, but typically is called capacity revenue. In practice, this term is used as a name for several different concepts. But whatever the name used, capacity auctions are becoming an important feature of the U.S. power-market landscape.

Capacity 101

Conceptually, there typically are two types of payments for capacity from a power plant. Essential to differentiating these two types of payments is indentifying who receives the benefit of the power plant’s gross margin. 3

In the first type, the capacity payment gives the buyer the right to the energy produced by the power plant at the energy’s variable cost of production. Purchasing the capacity and energy as a bundle like this sometimes is called a power purchase, as evidenced in the commonly used industry term “purchased-power agreement” (PPA). Such an arrangement is analogous to a call option on the energy price (or more precisely a call option on the spread between the plant’s fuel price plus VOM and the energy price), and is even sometimes called a “physical option.” A variant on this concept is a “tolling” payment, in which the buyer not only owns the energy output, but has the obligation to provide the power plant’s fuel. In either case, the gross margin between the power plant’s variable costs and the market price of energy is captured by the capacity buyer.

The opposite approach to defining capacity is a form in which the buyer has the right to the energy output of the power plant, but does not control the price at which it receives the energy output. Depending on the specific terms of the transaction, the buyer typically will have the right to call on the capacity of the plant at any time, but will pay the higher of variable production costs or the market price of the energy, 4 so the positive difference between variable cost and market price is retained by the power-plant owner. This type of capacity payment is sometimes referred to as the “reliability” or “regulatory” value of the capacity or, more colorfully, the “naked capacity” value of the power plant. The retention of the gross margin by the power-plant owner is typical of capacity transactions seen today in the administratively managed capacity markets in PJM, New York and New England. Just to add to the confusion, some markets also make “reliability must-run” (RMR) payments for capacity to ensure reliability, but such arrangements can assign the gross margin value to either the capacity buyer or the power-plant owner. RMR payments often are made for short periods of time (such as one year) and are subject to significant changes due to the development of new power plants or transmission lines.

Capacity payments made under PPA or tolling arrangements are higher than capacity payments made for the reliability capacity of the plant. This is a natural result of a PPA or tolling agreement giving the purchaser an opportunity to buy energy at a price lower than the market value of the energy. In the reliability