Meeting Slide 0405

Economics and Design of Capacity Markets for thePower Sector

Crampton and Ockenfels(2011)

April 5, 2012

Crampton and Ockenfels(2011) Economics and Design of Capacity Markets for the Power Sector

Economic Motivation for Capacity Markets

In this paper, they exclusively focus on capacity market.

The importance of generation capacity is emerging due to theincreasing demand, retirement of old plants, high pricevolatility and lack of a stable market framework.

Renewables increase price volatility and tend to reduce marketprice levels and worsen the capacity utilization of conventionalcapacity.


Economic Motivation for Capacity Markets(Cont’d)

Reliability of electricity supply is a particularly tricky issue inelectricity market in terms of time horizon.

This paper focuses on long-term issue of generation adequacy.

It considers a centrally-organized long-term capacitymarket(4-20 years) that complements the short-term andmedium term markets.

Reason for this is that a capacity market designed properlymay facilitate the solution to the resource adequacy problemas well as to some other problems such as inefficient pricingand market power.

An economically sound motivation for a capacity market mustargue that a capacity market can effectively mitigate manyproblems due to following unique properties of electricitymarkets.


1.Absence of demand response

Energy demand is technically inelastic. So market clearing inelectricity market is an illusory concept.

Due to insufficient demand flexibility, it is inevitable to faceinvoluntary load reduction when generation capacity is notadequate.


1.Absence of demand response(Cont’d)

What level of capacity provides optimal reliability?

The power market cannot provide an answer to this questiondue to externalities both on the demand and supply side.


Externality on demand side

Imperfect information about consumer’s valuation onreliability.

In this environment, reliability becomes a public good in whichconsumers have no incentive to reveal their true valuation onreliability.

This problem can be overcome with the development of smartgrid and metering solutions.

As of now, there is no way to identify how agents valuereliability. Hence, a market cannot determine the optimal levelof reliability.


Issues on supply side

Suppliers do not earn money in the blackout area, eventhough demand is large and capacity is scarce.

The incentive to provide the reserves may be too lowcompared to the incentive in an efficient market system,because all suppliers profit equally from the positive marketprice.

The incentive to invest in reserves is particulary small if theprice that can be reached in scarcity event is constrained.


1.Absence of demand response(Cont’d)

Given that a pure market design cannot reveal the informationnecessary to provide an optimal reliability level, the question iswhat determines resource adequacy and the degree ofreliability in pure-market design.

The answer is regulatory adjustment in interaction withmarket power.

Reliability can be the result of regulatory interventions.However, the optimal degree of reliability is not guaranteed.

Some argues that monopoly power can produce more thanenough reliability in the sense that market power affectsmarket entry and thus reliability.

A capacity market explicitly recognizes the need for anregulatory solution but can do better by minimizing marketpower.


2.Too low spot prices

Missing money problem: In normal periods, when there is noshortage of capacity, prices are below level needed to covercosts of new capacity.

In scarcity events, prices are unlikely to accurately reflect thescarcity.

With a well-designed capacity market, electricity prices arejust sufficient to pay for adequate capacity when capacity isadequate.


3.Non-optimal spot prices at scarcity events: Market power

Any pure-market solution needs capacity scarcity toincentivize new resources.

Since supply cannot do anymore to balance load and supply ina scarcity event, the demand side is required to bid prices upsuch that market clears.

In an efficient equilibrium, the resulting scarcity rents earnedin scarcity events are needed to cover the fixed capital andoperating costs of all resources.


3.Non-optimal spot prices at scarcity events:Marketpower(cont’d)

Capacity scarcity comes with market power.

One reason is that the competitors’ ability to substituteothers’ withheld capacity vanishes as one’s own capacityconstraints become tight.

Because scarcity is needed to provide incentives for newinvestment and because scarcity implies market powerpotential, any pure market design will sooner or later run intomarket power problems

The only way that extreme market power in scarcity eventscan be mitigated in pure market design is that market poweris already sufficiently large to attract new entry beforecapacity gets scarce.


3.Non-optimal spot prices at scarcity events:Marketpower(cont’d)

Capacity scarcity comes with market power.

One reason is that the competitors’ ability to substituteothers’ withheld capacity vanishes as one’s own capacityconstraints become tight

Because scarcity is needed to provide incentives for newinvestment and because scarcity implies market powerpotential, any pure market design will sooner or later run intomarket power problems.


4.Non-optimal spot prices at scarcity events: Regulation

Efficient scarcity prices can be very high. And the opportunityfor suppliers to exercise unilateral market power is also verylarge when capacity is scarce.

It seems difficult to distinguish efficient scarcity prices fromprices reflecting market power during scarcity events.

If prices never exceeded such incorrectly defined marginalcosts, the resulting revenues would be insufficient to attractsufficient entry, and the system would sooner or later collapse.

However, prices that exceed such estimates are threatened toinduce regulatory and political measures, possibly deterringnew investments.

There is no reason to suppose that scarcity prices accuratelysignal the need for new investment.


5.Price volatility and risks

Electricity markets are characterized by extreme pricevolatility. This induces costly risk to both sides of the market.

A major determinant of the volatility comes from the need ofthe market to incentivize entry of new capacity.

The price spikes due to scarcity events and the correspondingrisks on the supply and demand sides may be furthermagnified, both in the short- and long-term, by various otherfactors.

All these risks may discourage investors, or require asignificant risk premium.

Importantly, the reduction of risk does not come with areduction of price volatility. Risk is reduced by replacing peakenergy rents with a constant capacity payment.


6. Coordination failure

In a pure-market design, the decisions to build new capacityare made independently. This induces strategic uncertainty.

This is because ones investment in new capacity tends to bemore profitable if others invest less, there are incentives not toor to misinform competitors about ones own intentions.

Observe that without a capacity market, as the markettightens, it offers an increasingly large prize for the nextentrant. However, entry is a secretive process, and sosimultaneous entry is possible.

Aware of this, investors are torn between holding off until theprize is large enough to support some simultaneous entry andentering quickly to ward off competition. The optimalstrategy implies a random element and so the outcome islikely to be inefficient.


7. The (in)effectiveness of other solutions to deal withsuch challenges

Increasing demand response: But it still cannot solve missingmoney, market power problem.

Reserve power markets and capacity payments: Capacitypayments focus on short-term and medium-term. Thesepayments are not related to the costs of new capacity, thuscannot efficiently incentivize new entry.

Forward energy-only contracts: Hotel and Volkswagenexample. Investments are mostly based on expectations, noton the basis of locked-in forward contracts.


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Meeting Slide 0405