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Capacity Markets Demystified

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

Fortnightly Magazine - March 2008

from the energy market.

Each of these capacity markets is much more complicated than a quick summary can explain, and are in a near-constant state of flux. Also, while the process may be wrapped in science, there are ample opportunities to manipulate the outcome.

Energy-Only Markets

In energy-only markets, that is, markets without administrative capacity mechanisms, owners of unregulated power plants usually have two choices, namely,: 1) sell only energy; or 2) sell some combination of energy and capacity. Rarely would a new power-plant owner receive enough revenue in the “selling energy only” mode to produce an adequate return on investment, so that owner likely would make some capacity sales. This can take the form of either a PPA/tolling sale, which provides the energy to the buyer at cost, or a sale of reliability or regulatory capacity, which allows the power plant owner to realize any positive difference between production costs and the market price of energy.

In many of these energy only markets, there are state-level reliability mandates (sometimes referred to as “resource adequacy” requirements) that compel all LSEs to demonstrate an ability to serve their customers under peak demand conditions. 5 That is, there is a reliability requirement. In some markets, such requirements do not yet exist, but are likely to exist in response to the national mandatory reliability requirements in the Energy Policy Act of 2005. This typically can be met by self-owned generation or contracted generation. Such reliability requirements make it reasonable to assume that at least some power-plant owners will be able to receive contractual capacity payments in future markets.

This can be characterized as a “potential capacity” revenue source, which signifies that although there are logical reasons that some power plants will receive such revenue, there is no assurance that all qualified power plants will receive it, or receive it every year. Although the revenue stream is uncertain, forecasting potential capacity is a relatively simple process. The most economic source of new capacity typically is one with a relatively low capital cost, which is usually a natural gas-fired technology such as a combustion turbine (CT) or a combined-cycle (CC) power plant. Potential future energy market gross margins for these two technologies can be forecasted based on a dispatch analysis using an energy and fuel price forecast. The shortfall between each technologies’ levelized revenue requirements 6 and the forecasted energy gross margin is in essence a forecast of the capacity revenue each technology would require to enter the market. The smaller of the two shortfalls represents the cheapest method for an LSE to acquire reliability capacity, and hence becomes a forecast of potential capacity prices.

Revenue Risks

The unregulated merchant generator faces many risks to its expected revenues. Risk related to energy prices is relatively obvious; risk related to capacity prices is less so.

A common assumption is that capacity revenues are in some way less risky than energy revenues. In reality, capacity revenues can be even riskier than energy revenues, depending on circumstances. The specifics of these risks differ according to their causes. Namely: