Capacity MarketEdit
Capacity Market
The capacity market is a mechanism used in some electricity systems to ensure that sufficient reliable supply is available to meet demand during periods of peak usage. Rather than paying only for the energy that is produced, capacity markets provide payments to resources that agree to be available to produce electricity when the system needs it most. These resources can include traditional power plants, but increasingly encompass demand-side resources such as demand response and, in some designs, energy storage. The key idea is to translate the value of reliability into a forward-looking price signal so that investors and participating resources have a clear incentive to be ready to serve the grid when it matters most.
In markets that rely primarily on energy pricing, there can be a gap between the price signal for energy and the price signal needed to incentivize enough capacity to meet peak demand. Capacity markets attempt to close that gap by establishing forward auctions or other mechanisms that remunerate availability rather than actual energy delivered. The design and operation of capacity markets vary by region, but the common elements typically include a reliability standard, a forward capacity auction, performance obligations, and penalties or de-commitment rules for underperformance. The structure is typically overseen by an independent system operator or other market operator, with regulatory review to ensure that practices remain fair and transparent.
Capacity markets operate within broader electricity market frameworks that include energy markets, ancillary services, and sometimes carbon or other policy signals. They interact with regional transmission planning, incentives for new generation and transmission, and policies aimed at ensuring resilience in the face of fuel supply disruptions, extreme weather, or rapid shifts in the generation mix. In many cases, the capacity market is designed to complement an energy market by providing long-term price signals that help finance the construction or retention of reliable capacity, while continuing to rely on energy prices to determine the value of actual production.
How capacity markets work
Resource types: Capacity resources typically include existing power plants that commit to be available during peak periods, as well as demand-side resources such as load relief through demand response and, in some regimes, energy storage that can be dispatched to contribute to reliability. See demand response and energy storage for related concepts.
Forward auctions: A capacity market usually conducts annual or multi-year forward auctions to determine the amount of capacity that must be available in the delivery year. The auction clears at a price that sets the value of capacity for that period.
Obligations and payments: Resources that clear in the auction receive capacity payments in exchange for an obligation to be available and to meet reliability performance criteria. Payments are typically separate from energy payments and are designed to stabilize the revenue streams for enduring reliability investments.
Performance and penalties: If a resource fails to deliver as promised during a delivery year, penalties or true-up charges can apply to recover the value of the shortfall. Performance metrics are set by the market administrator and may include reliability criteria, availability factors, and other baseline requirements.
Interaction with energy markets: Capacity payments provide a revenue stream that supports investments in capacity, while energy market prices continue to determine operating revenue based on actual production. The two markets together aim to balance the incentives to build and maintain reliable resources with the cost and value of energy on the system. See electricity market for the broader context.
Regional operators: In the United States, major capacity markets are organized under regional market operators such as PJM Interconnection and ISO New England, with additional arrangements in other markets. These entities coordinate planning, procurement, and performance oversight. See PJM Interconnection and ISO New England for more details. International examples exist as well, with various forms of capacity mechanisms in operation in other jurisdictions such as the United Kingdom capacity market.
Regional implementations
North American markets: In large parts of North America, capacity markets are used to supplement energy markets and maintain resource adequacy. The capacity market framework typically includes a forward capacity auction, capacity obligations, and penalties for under-delivery, with resources that can include conventional generators, demand response, and sometimes storage. See PJM Interconnection and ISO New England for representative designs, and New York Independent System Operator for the capacity arrangements in New York.
United Kingdom and other jurisdictions: Some European and other markets employ capacity mechanisms that resemble a capacity market, with government or regulator oversight and annual or multi-year auctions to secure reliability capacity. See Capacity market in the United Kingdom for an example of how a capacity mechanism has been implemented in a mature liberalized system.
Design variations: Key design choices across regions include the length of forward contracts (e.g., one-year vs multi-year), the treatment of demand-side resources, the treatment of energy efficiency and retirement of capacity, how penalties are assessed, and how cross-border or regional resource sharing is handled. These differences reflect local policy goals, regulatory environments, and the evolving balance between reliability, affordability, and emissions objectives.
Economic and policy implications
Reliability and price signals: Proponents argue that capacity markets provide important reliability insurance, particularly in systems with high shares of intermittent or variable generation, by giving investors a clear, long-horizon revenue stream to fund reliable capacity. Critics contend that capacity payments can inflate consumer costs or subsidize uneconomic plants if not carefully designed, and that alternative approaches could achieve reliability at lower total cost.
Consumer costs and affordability: The question of who bears capacity payments—ratepayers, taxpayers, or other market participants—raises debates about fairness and affordability. Critics warn that subsidies to existing plants can slow the retirement of inefficient older facilities or impede the entry of newer, cleaner resources if not designed to reflect true marginal value.
Investment signals and market power: Capacity markets aim to improve investment signals for reliable capacity, but there is concern that market power, bidding behavior, or regulatory constraints could distort prices and lead to over-procurement or under-procurement under specific conditions. Regulators and market operators monitor performance, scrutinize bids, and adjust rules to curb manipulation and ensure transparency.
Transition and decarbonization: As economies pursue emissions reductions and cleaner energy mixes, capacity markets must adapt to incorporate low- or zero-emission technologies, energy storage, and flexible demand. Integrating these resources into capacity constructs raises questions about eligibility, measurement of reliability contributions, and the alignment of subsidies with environmental goals. See renewable energy and energy storage for related considerations.
Alternatives and complements: Some policymakers favor strengthening energy markets, demand-side management, or long-term contracting as ways to ensure reliability without introducing separate capacity payments. Others argue that a well-designed capacity market can complement these approaches, providing a hedge against peak demand and reliability risk while allowing market participants to monetize the value of being ready to serve.
Controversies and debates
Cost versus reliability: A central debate centers on whether capacity payments deliver reliability at acceptable cost. Supporters emphasize reduced risk of blackouts and smoother investment cycles; critics worry about higher consumer bills and the potential for subsidizing fossil-fuel plants or older assets that would not be economically viable in a stricter, energy-only regime.
Incentives for incumbents versus entrants: Some observers worry that capacity markets can entrench existing generators by guaranteeing revenue streams that favor established incumbents, potentially limiting competition and raising barriers for new, cleaner entrants. Advocates argue that the presence of competitive auctions with clear performance criteria can still foster new entry, including cleaner technology and demand-side participation.
Alignment with decarbonization: In regions pursuing aggressive decarbonization, there is debate about whether capacity markets should explicitly value carbon emissions trajectories and support cleaner resources or whether they should be technology-agnostic. The design challenge is to avoid creating perverse incentives that slow the retirement of high-emitting plants while still ensuring reliable operation during extreme conditions.
Demand-side participation: The extent to which demand response and storage should count toward capacity is a live issue. Proponents note that flexible demand and storage can provide substantial reliability value at lower long-run cost; opponents worry about measurement, verification, and the risk of over-committing uncertain resources. See demand response and energy storage for related discussions.
Regulatory and political dynamics: Capacity market design often reflects a balance of interests among regulators, market operators, industry participants, and policymakers. This can lead to revisions in auction rules, performance criteria, and eligibility standards as conditions change—such as growing renewable generation, retirements of conventional plants, or shifts in energy policy.