19 Aug 2015 | Jakob Schlandt

Capacity markets around the world

UPDATE - Germany has opted against a large-scale capacity mechanism despite its increasing international popularity – from an idea to support power plants on the United States’ eastern coast to many European countries introducing payments for capacity. Experiences, however, have been mixed. Appropriate regulation is crucial – the devil is in the details. This factsheet gives an overview of approaches around the world.

Australia

Western Australia, which is not connected to the rest of the country’s grid, introduced a capacity market mechanism for its main grid nearly a decade ago, amid fears of a future power shortage. Now, prices are considerably above the national average, although this is linked to a number of reasons. Payments to power plants under the so-called reserve capacity mechanism (RCM) are based on predictions of future power needs. But estimates were too high, resulting in overcapacity and higher bills for consumers. This case is often cited in the press as a “cautionary tale” on capacity markets. Currently, reform of the system and even the return to an energy-only market (EOM) is being discussed.

 

USA

The California electricity crisis in 2000 and 2001 was a shock for the whole US. Problematic regulation combined with market manipulation by companies such as Enron (which later went bankrupt) led to massive and prolonged blackouts and brownouts (a drop in voltage), hitting consumers and industry. Numerous grid operators reacted by putting capacity mechanisms in place, though others simply reformed the energy-only market. Consequently, the US now has the most diverse electricity market landscape of any individual country in the world. The most important grid operator with a capacity mechanism is PJM Interconnection, which serves 13 states and Washington D.C. California, among others, has had a capacity system in place since 2007. Overall, capacity markets have been successful in delivering long-term stability of power supply. Even though prices for capacity are highly volatile, investments in new capacity still takes place. On the other hand, there is substantial criticism that capacity markets result in windfall profits for the owners of existing power plants and cost the consumer too much. The overall price tag for the PJM capacity market is currently put at more than 7 billion dollars per year, but there are also offsetting savings for consumers because peak prices are lower due to the increased supply. Recently, a substantial upgrade of the PJM was introduced. The performance and reliability of capacity sellers has to improve and penalties for non-delivery are increased. Early in 2014, a stretch of extremely cold weather had led to increased power station failures and a tight supply situation in the PJM grid.

Other market zones in the US, however, employ energy-only markets, where the sole compensation for owners of power plants is the price per kilowatt hour produced. The most commonly used example is the ERCOT grid in Texas where sufficient generation is supported by letting prices run high in times of scarcity. Extreme price peaks are even encouraged by the regulator. Initially, it was argued that the energy-only system was working well in Texas and spared consumers additional cost. Recently, however, there have been growing concerns that the Texan approach might not deliver. In some winters, electricity conservation had to be encouraged to ensure the stability of the power system. There is an ongoing discussion about the introduction of a capacity scheme in the ERCOT grid.

 

United Kingdom

The UK, where fears of power shortages are widespread, recently introduced a capacity market. The design is centralised and encompassing: The needed capacity is determined by government and then bought on the market via an auction from the lowest bidder, which faces harsh penalties if it fails to deliver. The first successful auction took place last December for the provision of sufficient capacity in the winter of 2018/19 at a cost of nearly 1 billion pounds. The British government secured capacity of just over 50 gigawatts (GW) for the first period of delivery in 2018/19. The auction for the following winter will take place in December 2015. However, capacity markets could be prone to manipulation, too. Recently, market regulator Ofgem opened an investigation because it suspected that five companies might have given misleading information about their plans for new power stations. Criticism of the scheme focusses on the cost for consumers, that coal instead of more eco-friendly gas power stations are the main beneficiary, and that there is so far little evidence that new investment is spurred.

 

France

France is also introducing a capacity mechanism, but has chosen a decentralised design. Electricity retailers are obliged to secure capacity in accordance with the peak demand of their customers for up to four years in advance. To do so, they must buy capacity certificates from power station operators. The system is supposed to become operational in the winter of 2016/17 and the price formula will have to be determined, at the latest, towards the end of next year. France has enormous capacity needs during cold winters because much of its heating depends on electricity. Neighbouring Belgium wants to subsidise investment in new gas generation capacity.

 

Rest of the European Union

The European Commission gives an overview of existing capacity mechanisms in Europe. Greece, Ireland, Italy, Spain, Sweden, Finland and Poland all use some sort of mechanism to ensure that power plants can meet demand. In Spain, for example, most support goes to investors in new capacity, so the mechanism is strongly selective. In Italy, after the blackout of 2003, a provisional system was put in place that is supposed to be replaced by a long-term capacity market. Yet introducing capacity mechanisms is not an irreversible trend – Portugal effectively suspended its capacity scheme in 2012 amidst overcapacity concerns. The Commission’s report estimates that the costs of capacity markets are substantial, but not excessive. However, the Commission in April started an inquiry to find out more about the different capacity mechanisms across Europe and will publish a report about if and how they could distort markets. First results are to be expected by the end of 2015 and a full report by mid-2016.

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Dossiers

This Factsheet is part of the following Dossiers: