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Explore the rationale for capacity markets in the energy industry, discussing challenges, market failures, and suggested solutions. Learn about the impact of market power, regulatory responses, and price management strategies. Discover a proposed solution to replace price spikes with a Licap model, aiming to eliminate market power, incentivize reliable energy sources, and calibrate for desired reliability levels.
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A Capacity Marketthat Makes Sense Peter Cramton & Steven Stoft3 June 2005
Other industries don’t have one Short run Price Supply Long run E(Rent) = Fixed cost P* Inframarginal rent Demand Quantity
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
Traditional ICAP Market Demand Price True supply Competitive price = $0 Quantity
Traditional ICAP Market Demand Price True supply Bid supply $999 Profit from exercise of market power Competitive price = $0 Quantity
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
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
A Better Solution: Replace price spikes with LICAP • Eliminate the bad aspects of price spikes • Retain the good aspects
Replace price spike with LICAP Note extreme sensitivity to capacity level Price LICAP Demand Curve 2EBCC 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)
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
1. Eliminate market power in LICAP market LICAP market clearing • Suppliers bid as they wish • Clearing price determined by actual capacity Price 2EBCC Supply offered EBCC Clearing Price Demand Capacity Criterion Target Actual EBCC = expected benchmark carrying cost (annualized fixed cost of frame unit)
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
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
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