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By Adam James
I have a confession to make. I am one of those folks who consistently write on wonky energy things without ever taking the time to write out simple explanations of the basic concepts or why they matter.
So, this piece will give a brief description of what electricity capacity markets are and how they work.
Part One: What is a Capacity Market?
There is a difference between energy and capacity, and power plants are compensated for both because both are important to maintaining the electrical system in different ways.
Here is the distinction. A power plant generates electricity that you use in your home—and it needs to be paid for that electricity. This happens in the energy market. In these markets electricity is like any other commodity, bought wholesale and resold to consumers at retail prices.
However, some grid operators are experimenting with capacity markets, or “forward markets,” which direct investment a few years ahead of when electricity needs to be delivered. This is important, since power plants are expensive and take a long time to build; adding the additional risk that they may not even be used can obviously discourage investment. Hopefully, these markets create long-term price signals for all resources.
The basic idea is that power plants receive compensation for capacity, or the power that they will provide at some point in the future. The way these markets are run in the PJM territory, there is an auction every year that has a delivery date three years away. This auction is called the Base Residual Auction. Then, there are smaller balancing auctions every year leading up to the delivery date where bidders can buy or sell their commitments. These are called “Incremental Auctions,” and occur just in case a power plant cannot meet its commitment, and needs to purchase replacement capacity from another power plant.
One quick note here: in these auctions, there is no functional difference between a megawatt of power from a power plant and a megawatt of reduced power from efficiency or demand response. So although I’ve been saying “power plants” to help picture this process, demand-side resources can also bid into the auction.
Part Two: How Do Capacity Markets Work?
Every resource bids into the auction at its total cost of operation. Since power plants depreciate over time, this bid can sometimes be very low if a plant has been around for a long time. This makes sense, since the capital investments in the plant have been paid off and the total cost of operations is mostly employees and fuel. New plants total cost of operation is higher at first, since it would include the capital costs plus the operational costs.
This means that what price a power plant bids into the market can vary quite dramatically. A 30 year old nuclear plant could actually bid in very low and a wind turbine that has zero fuel costs could have a much higher bid.
So what happens is that the grid operator holds an auction based on projections for what electricity demand will be in three years. When I say “electricity demand,” I actually mean peak demand for that entire year, plus a bit extra as a buffer (called a capacity margin).
Let’s look at a practical example, accompanied by a picture.
Pretend that the grid operator had to meet 550 megawatts of demand. This is absurdly low of course, it’s closer to 170,000 in PJM, but the process is much easier to imagine with smaller numbers. The grid operator will hold then hold an auction to try to get the 550 megawatts of demand met at the lowest cost to consumers.
So then every resource bids into the auction in at its total cost of operation. In our hypothetical auction below, I’ve arranged the stack from lowest to highest cost bids, and drawn a line at the point where enough capacity has been acquired to meet demand.
As you can see here, the cheapest resource is one wind turbine bidding in 50 MW of capacity at $30 per MW. But wait! Just because they bid in $30 per MW, that does not mean that the turbine receives 30 per MW. All it means is that the wind turbine is now committed to have 50 MW of power available in 3 years from now. Looking further up the stack, another turbine bids in 50 MW at $50 per MW. Even higher up the stack, you can see efficiency bid into the auction at $130 per MW, and a coal plant bid in at $150 per MW.
So what compensation do they receive? In this example, all of the resources, including the wind turbine at the bottom, receive $150 per MW. This is called the “clearing price,” and it is set by the most expensive unit needed to meet demand. In this case, that is the coal plant (shown in orange).
This is important to understanding the dynamics between different resources in the market.
In this example, efficiency actually displaced a coal plant (shown in purple) whose total cost of operation was $160 per MW. Think about it this way; if efficiency had not bid into the market, then demand would have been 100 MW higher and that coal plant would have to be called on to meet demand. Then the clearing price would have been $160 per MW.
For what it’s worth, because there is the Base Residual Auction followed by a few Incremental Auctions, there can actually be some weird exchanges. In our example, imagine that the coal plant receives the $150 capacity payment but then goes offline due to equipment malfunction. Suddenly, they are on the hook for 150 MW of capacity that they cannot provide. So, in the next Incremental Auction they sell their 150 MW commitment.
If the clearing price in the Incremental Auction comes in at $130 per MW, the coal plant has (oddly enough) made $20 per MW. This is because they got $150 for something that someone else is now going to do for them for only $130.
The other story here is that in capacity markets, lower cost resources can have the effect of suppressing prices for all of the resources since they ensure that demand can be met at a lower cost. For utilities who own lots of expensive generation, this is bad for business. For a company who owns lower cost resources, it is good. Consumers always benefit from lower prices.
Capacity markets are important. They are the firing line for the electricity system of the future, because they direct and encourage investments in different kinds of assets—whether that is clean energy, fossil fuels, or demand side resources like efficiency. A book could be written on the criticisms of capacity markets, details on how these markets function, and how they can be harnessed more effectively, but this should give a good overview of the nuts and bolts.