Energy Analysts Offer Fixes for Six Capacity Market Flaws

As capacity markets offer up more incentives for electricity generators to invest in meeting future demand, regulatory schemes in Europe offer valuable lessons for evolving energy landscapes worldwide.

“Over the last decade Europe has witnessed the growth of capacity remuneration mechanisms (CRMs),” writes the Brussels-based Regulatory Assistance Project (RAP). With investments in grid capacity and diversity becoming crucial, especially as intermittent sources like wind and solar increasingly feed grids, a deep dive by RAP provides insights into CRMs, their drawbacks, and how to mitigate them.

How Do CRMs Work?

“The overall aim of the CRM is to ensure security of supply, as well as ensuring that consumers don’t pay for more capacity than is needed,” explains SEM Committee,. Ireland’s grid operator. They’re meant to provide advance payments to power producers so they’ll invest in new capacity a few years before the electricity is actually needed.

Capacity markets define payment methods, rules, and rates, and can take different forms, including auctions among potential suppliers or other designs. They’re becoming an important policy option on a global path to greater electrification, but they do come with some downsides.

RAP evaluates a number of mechanisms, but specifically flags long-standing concerns with forward capacity markets. It cites “reserve scarcity pricing” systems that adjust electricity rates during periods of shortage as a more transparent, consumer-focused alternative.

Poor Incentives Can Make Capacity Markets Fail

Historically, some capacity markets have failed to provide stable electricity supply when power producers fail to honour their contracts, either by neglecting to build new resources fast enough or by not ensuring that a plant is available when needed. This can happen when law prequalification requirements allow “paper projects” to win capacity contracts before they’re far enough along in their development. Capacity markets are more likely to fail if penalties are too low to enforce compliance, or deposits are too modest to weed out unqualified suppliers.

RAP recommends higher deposits to discourage bids on behalf of immature projects, and strict enough penalties to ensure that winning bidders deliver the capacity they promised when it’s needed.

Capacity Markets Tend to Procure Too Much Power

When capacity markets centralize decisions on electricity supply and demand, regulators are motivated to over-insure against shortages, leaving the costs of preventing power shortages to be borne by consumers in the form of higher energy bills.

RAP says grid operators can avoid the bias for excess capacity by engaging technical experts and conducting resource assessments to more accurately calculate the risks. Neutralizing conflicts of interest—by decentralizing responsibility for procuring capacity and setting up a fully independent system operator—can also help.

Reserve Scarcity Pricing Drives Up Capital Costs

RAP sees reserve scarcity pricing as the best CRM option, even though it can saddle consumers with higher capital costs and raises concerns about government intervention when power prices are high. Those features of a reserve scarcity pricing system can raise flags with investors compared to capacity markets.

But RAP argues against the centralized regulation that capacity markets foster, suggesting a series of reforms to boost investors’ confidence that they’ll recover their costs. Options include measures to protect vulnerable consumers and financial market solutions to stabilize bills.

Capacity Markets Dampen Interest in Demand Response

Though capacity markets are designed to increase supply, they often fail to adequately support demand-side options that give power users an incentive to reduce consumption during periods of peak demand. That means they miss the full benefit of the avoided costs that might be available across the system.

“This matters because it sustains the bias against demand-side resources crucial in accommodating massive growth in variable renewables at least cost,” writes RAP.

The blueprint says grid operators can support efficient incentives for demand response by targeting recovery charges to coincide with periods of scarcity. While the approach does nothing for low-income consumers who already limit their electricity demand, RAP says it still reduces overall capacity needs and system costs, and “there are better ways to protect the energy poor than by deliberately distorting the market.”

Capacity Markets Struggle to Boost Competition

European regulations are meant to minimize market distortions by opening capacity markets to cross-border participation. RAP says centralized capacity auctions still “struggle to provide a fully level playing field for foreign resources,” resulting in uncertainty about whether capacity will be contracted across multiple jurisdictions. But tougher regulations can better ensure fair participation for foreign resources.

Grid operators can also level the playing field by reducing conflicts of interest and reflecting the full value of resources in real-time markets.

Long-Term Contracts May Lock In Dirty, Inefficient Power Production

Capacity markets based on long-term contracts can lock in current technologies and slow down the adoption of new technologies. The failure to innovate can drive up consumer costs and can offset or overwhelm the savings a grid might hope to achieve with longer-term contracts that qualify for lower capital costs.

Regulations like carbon pricing and tighter emissions standards can prompt competitors to consider the longer-term competitiveness of current technologies as lower-emissions options become available. But RAP says a better option is to do away with long-term contracts altogether.