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Economics of Energy & Environmental Policy
Volume 2, Number 2

Capacity Markets - Lessons Learned from the First Decade

Kathleen Spees, Samuel A. Newell, and Johannes P. Pfeifenberger

DOI: http://dx.doi.org/10.5547/2160-5890.2.2.1
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Capacity markets were introduced in the U.S. in the late 1990s as a means to ensure "resource adequacy" in liberalized electricity markets where generation must be built by merchant investors rather than regulated entities. This paper provides a general introduction to these markets: why they exist, how they function, how well they have performed in their first decade of operation, and the current challenges they face. It shows that capacity markets can work to meet their objectives but will need to address various design challenges over the coming years. Keywords: Capacity markets, Resource adequacy, Liberalized electricity markets

Capacity Market Fundamentals

Peter Cramton, Axel Ockenfels, and Steven Stoft

DOI: http://dx.doi.org/10.5547/2160-5890.2.2.2
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Electricity capacity markets work in tandem with electricity energy markets to ensure that investors build adequate capacity in line with consumer preferences for reliability. The need for a capacity market stems from several market failures. One particularly notorious problem of electricity markets is low demand flexibility. Most customers are unaware of the real time prices of electricity, have no reason to respond to them, or cannot respond quickly to them, leading to highly price-inelastic demand. This contributes to blackouts in times of scarcity and to the inability of the market to determine the market-clearing prices needed to attract an efficient level and mix of generation capacity. Moreover, the problems caused by this market failure can result in considerable price volatility and market power that would be insignificant if the demand-side of the market were fully functional. Capacity markets are a means to ensure resource adequacy while mitigating other problems caused by the demand side flaws. Our paper describes the basic economics behind the adequacy problem and addresses important challenges and misunderstandings in the process of actually designing capacity markets. Keywords: Capacity markets, Market failures, Resource adequacy

Capacity Markets in PJM

Joseph Bowring

DOI: http://dx.doi.org/10.5547/2160-5890.2.2.3
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The PJM capacity market evolved from a mechanism to support fair and efficient retail competition, to a core market design component implemented to provide adequate revenue to attract sufficient supply and demand side resources to meet PJM's administrative reliability criteria. The lessons learned in the evolution of the PJM capacity market illustrate issues that are shared across all wholesale power markets. An exogenously imposed administrative reliability requirement has generally been interpreted to require the ownership of, or contracts for, capacity in excess of expected peak loads by a reserve margin. In PJM, the reserve margin requirement resulted in a level of capacity greater than would have been the result of the operation of an "energy only" market without such a requirement. The result was lower energy prices for all units and a shortfall of net revenues compared to the annualized costs of building a new generating unit. The early wholesale power market designs, including PJM, replicated the efficient dispatch of a tight power pool, but did not address the sources of revenues to cover the costs of investment in new and existing generating capacity and thus did not address the endogenous sustainability of the market design consistent with administrative reliability criteria. The introduction and redesign of a capacity market has largely solved this "resource adequacy" problem. But the PJM capacity market design continues to be imperfect and the resolution of the remaining design issues is critical to the continued success of the PJM market as demand increases and generating units retire. Keywords: Capacity Market, PJM Interconnection, RPM, Minimum Offer Price Rule

Electricity Scarcity Pricing Through Operating Reserves

William W. Hogan

DOI: http://dx.doi.org/10.5547/2160-5890.2.2.4
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Suppressed prices in real-time markets provide inadequate incentives for both generation investment and active participation by demand bidding. An operating reserve demand curve developed from first principles would improve reliability, support adequate scarcity pricing, and be straightforward to implement within the framework of economic dispatch. This approach would be fully compatible with other market-oriented policies. Better scarcity pricing would also contribute to long-term resource adequacy. Keywords: Electricity scarcity pricing, Resource adequacy, Operating reserves

Transparency in Electricity Markets

Nils-Henrik M. von der Fehr

DOI: http://dx.doi.org/10.5547/2160-5890.2.2.5
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The European Commission is introducing new regulations on submission and publication of data in electricity markets (SPDEM) and on wholesale energy market integrity and transparency (REMIT). I discuss issues relevant for undertaking an evaluation of such regulations. I argue that, for market performance, more information is not always better; indeed, more information may undermine market performance by facilitating behaviour that is either not cost efficient or aims at exercising market power or establishing and maintaining collusion. Moreover, ensuring rational economic behaviour and an efficient and competitive market outcome does not require general access to information at a very detailed level or with a high degree of immediacy. I conclude that to achieve the aims of efficiently functioning wholesale electricity markets, fair and non-discriminatory access to data and a coherent and consistent view of the European wholesale electricity market, it does not seem advisable to go quite so far with respect to immediacy and detail as intended by the new regulations. Keywords: Electricity, Market performance, Information, Transparency, Regulation

European Electricity Market Reforms: The "Visible Hand" of Public Coordination

Dominique Finon and Fabien Roques

DOI: http://dx.doi.org/10.5547/2160-5890.2.2.6
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The paper investigates how proposed reforms on policies to maintain generation adequacy and to encourage clean technology investments in a number of European countries, modify the role of the market. This is reduced as the government, regulator and system operator take on explicit responsibility through the introduction of capacity mechanisms and long-term support for clean technologies. We highlight the interaction of these mechanisms with the electricity market and we look at how they reallocate risks between generators, government and consumers. The different mechanisms offer varying degrees of autonomy to generators with regards investment decisions. Looking towards the future, the paper also explores how designs of mechanisms might move towards a technology-neutral mechanism in the long-run. This could involve the auctioning of long-term contracts for all types of existing and new capacities, whether it be low carbon or fossil fuelled. Keywords: Capacity mechanism, Renewables policies, Long-term contracts, Electricity markets

EU ETS Phase 3 Benchmarks - Implications and Potential Flaws

Stephen Lecourt

DOI: http://dx.doi.org/10.5547/2160-5890.2.2.7
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In Phase 3 (2013-20) of the European Union Emissions Trading Scheme, the allocation methodology has shifted from grandfathering to a combination of auctioning and benchmark-based free allocation in the framework of Community-wide rules. Free allocation will apply mainly to non-electricity generators, and will decrease linearly throughout the phase with a view of ending free allocation by 2027. Benchmark-based free allocation is intended to reward the least CO2-intensive installations and thus provide an incentive to reduce greenhouse gas emissions. This policy note describes the concrete changes implied by this shift in allocation methodology, and identifies potential flaws in the new transitional Community-wide rules for free allocation, thereby contributing to the discussion on the need for structural reforms in the ETS. Keywords: EU ETS, Benchmarks, Preliminary amounts, Carbon leakage, Historical Activity Level

Technological Advance in Cooling Systems at U.S. Power Plants

Allen Bellas, Duane Finney, and Ian Lange

DOI: http://dx.doi.org/10.5547/2160-5890.2.2.8
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Prior to adoption of the 1972 Clean Water Act (CWA) most U.S. power plants used once-through cooling water systems that discharged large quantities of warm water. This resulted in significant amounts of thermal pollution in neighboring bodies of water. The CWA essentially mandated recirculating systems for new facilities. This paper investigates whether there was technological advance in cooling systems, which we define as reductions in performance-adjusted costs, and how these advances are related to imposition of the CWA. Results suggest that the performance-adjusted cost of installing a recirculating cooling system was falling prior to implementation of the CWA but rose thereafter. This is consistent with the theoretical work suggesting that command and control regulation offers poor incentives for advances in pollution control technology. Keywords: Electricity generation, Water cooling, Innovation, Environmental policy

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