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Capacity Markets Demystified

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

Fortnightly Magazine - March 2008

capacity arrangement, the purchaser never receives energy at a price lower than the current value of the energy. The capacity payment made under a PPA/tolling agreement is a function of the efficiency of the power plant. Buyers of PPA/tolling capacity must be willing to make a relatively higher capacity payment for units with good heat rates as opposed to units with poor heat rates. The good heat rate results in more hours when the plant is “in the money,” and hence creates a higher level of operating profit.

A plant owner that is considering selling its capacity can choose to sell either PPA/tolling capacity or reliability capacity. If the product sold is reliability capacity, then the owner of the plant will receive lower capacity revenue, but will retain the profits that result from any energy produced at a cost lower than the current energy price.

Administrative Capacity Markets

In most of the United States, revenue from energy and ancillary services usually are insufficient to cover the production costs, fixed O&M, and capital charges for new generation. For new generation to enter the market, generators rely on capacity payments to supplement their energy and ancillary- services revenue streams.

Increasingly, capacity markets are becoming an important market driver, and there is optimism by many market participants and regulators that these markets will provide sufficient incentives to induce entry of new capacity to secure future reliability. The capacity markets in PJM, NYISO, and ISO-NE still are evolving, and further modifications can be expected. However, they do have common elements (see table, “Northeastern U.S. Capacity Markets”) .

In each of these three markets, auctions are held under a prescribed set of rules to arrive at capacity prices (often referred to as installed capacity, or “ICAP,” prices). The auction rules and the period of time to which the capacity payments pertain vary widely by market. Also, the Northeast capacity markets often can be circumvented by either: 1) bilateral contracting between power plant owners and load serving entities (LSEs); or 2) LSE self-generation. A common problem in today’s ICAP markets is that the period of payment is much shorter than the life of a new power plant, creating a significant source of financial risk for the power-plant owner.

The distribution of loads and resources isn’t uniform within each of these markets, and due to transmission limitations, there are geographically varying values for capacity. The three ICAP markets generally acknowledge this and are attempting to incorporate geographic issues into the capacity markets.

All three capacity markets use a mechanism to set a ceiling on capacity prices in an attempt to limit the potential for market manipulation. In each case, the ceiling is a function of the cost of new entry (CONE), which has proven to be a much-debated value. The CONE is set administratively through a contentious administrative process and is subject to various political and economic pressures. The mechanism by which the CONE is translated into the ceiling price varies widely by market, but a common theme is that the CONE gets reduced by some allowance for profits