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Optimal Capacity Mechanisms for Competitive Electricity Markets

Pär Holmberg and Robert A. Ritz

Year: 2020
Volume: Volume 41
Number: Special Issue
DOI: 10.5547/01956574.41.SI1.phol
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Abstract:
Capacity mechanisms are increasingly used in electricity market design around the world yet their role remains hotly debated. This paper introduces a new benchmark model of a capacity mechanism in a competitive electricity market with many different conventional generation technologies. We consider two policy instruments, a wholesale price cap and a capacity payment, and show which combinations of these instruments induce socially-optimal investment by the market. Our analysis yields a rationale for a capacity mechanism based on the internalization of a system-cost externality�even where the price cap is set at the value of lost load. In extensions, (i) we show how increasing variable renewables penetration can enhance the need for a capacity payment under a novel condition called "imperfect system substitutability" , and (ii) we outline the socially-optimal design of a strategic reserve with a targeted capacity payment.



A Survey of Capacity Mechanisms: Lessons for the Swedish Electricity Market

Par Holmberg and Thomas Tangeras

Year: 2023
Volume: Volume 44
Number: Number 6
DOI: 10.5547/01956574.44.6.phol
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Abstract:
Many electricity markets use capacity mechanisms to support producers. Capacity payments can mitigate imperfections associated with "missing money" in the spot market and solve transitory capacity shortages caused by investment cycles, regulatory changes, or technology shifts. We discuss capacity mechanisms used in electricity markets around the world. We argue that correctly designed strategic reserves are likely to be more efficient than market-wide capacity mechanisms in jurisdictions that rely on substantial amounts of variable renewable energy and hydro power for electricity supply, such as Sweden.





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