A Capacity Market that Makes Sense

1. A Capacity Marketthat Makes Sense Peter Cramton & Steven Stoft3 June 2005

2. Why a capacity market at all?

3. Other industries don’t have one Short run Price Supply Long run E(Rent) = Fixed cost P* Inframarginal rent Demand Quantity

4. Why capacity market at all? • Market failure • Absence of demand response • Supplier market power especially in load pockets • Regulatory response • Prices are capped at $1000/MWh ($250 in California) • Supply offers are “mitigated” if much over MC(PJM: MC + 10% in load pockets) • Result • Generators cannot cover FC from energy revenues

5. Traditional ICAP Market Demand Price True supply Competitive price = $0 Quantity

6. Traditional ICAP Market Demand Price True supply Bid supply $999 Profit from exercise of market power Competitive price = $0 Quantity

7. Traditional ICAP Market • Pays based on “availability” • Available if you say you are, and there is no compelling evidence otherwise • Result • “Dog” plant gets large capacity payment • Slow start • Extremely high marginal cost • Never called (even in crisis) • Always appears available • Does not contribute to reliability

8. VOLL pricing: administrative price spike Price • Carrying costs paid by • Infra-marginal rents • Price spikes when short • Big enough price spikes  reliability • Infra-marginal + spikes  right generation mix Infra-marginal rents Peakers: old / new Shoulder Base Variable Cost Quantity • Problems • $15,000 price spikes due to weather / outages too risky • Spike payments too sensitive to over/under capacity • Too tempting for the exercise of market power

9. A Better Solution: Replace price spikes with LICAP • Eliminate the bad aspects of price spikes • Retain the good aspects

10. Replace price spike with LICAP Note extreme sensitivity to capacity level Price LICAP Demand Curve 2EBCC Price-Spike Revenue Curves EBCC Weather / outage risk, year-to-year fluctuation Target Capacity Capacity EBCC = expected benchmark carrying cost (annualized fixed cost of frame unit)

11. Four essential features • Eliminate market power in LICAP market • Eliminate incentive to create real-time shortages • Reward the reliable • Calibrate demand curve for desired reliability

12. 1. Eliminate market power in LICAP market LICAP market clearing • Suppliers bid as they wish • Clearing price determined by actual capacity Price 2EBCC Supply offered EBCC Clearing Price Demand Capacity Criterion Target Actual EBCC = expected benchmark carrying cost (annualized fixed cost of frame unit)

13. 2. Avoid incentive for real-time shortages • LICAP payment = LICAP Price – “Peak Energy Rent” • “Peak Energy Rent” = actual inframarginal energy rents of efficient benchmark peaker • No incentive for supply to create real-time shortages • Avoids controversy of estimating energy rents • Reduced risk for suppliers and load • Prevents supply from using threat of shortages to negotiate more favorable long-term contracts • Removes administrative shortage price from efficient long-term contracts

14. 3. Reward the reliable • Available means “during shortage hours” • If 90% available during shortages,get 90% of full LICAP price • Shortage hours = insufficient operating reserves • Available = providing energy or reserves in shortage hours • Slow-start offline resources are deemed “unavailable,” because these resources could not capture price spike • Prevents high-cost inflexible resources from collecting LICAP • Load should not pay for “capacity” that cannot produce during a shortage—that capacity does not contribute to reliability • Availability smoothed to reduce risk

15. 4. Calibrate for desired reliability

16. Conclusion: It makes sense • Economic LICAP has these advantages: • Addresses market power (spot energy and LICAP) • Reduces profit risk  lower cost • Incentive for efficient generation mix