Different Markets: Energy versus Capacity

By EnPowered - November 04, 2020

In a certain sense, electricity markets are like your cell phone plan (no, really!). EnPowered simplifies energy management.

When it comes to our data plans we’re all familiar with the two standard payment options: pay by use or a set monthly data quota. Both options have their advocates, and a similar distinction is at work in electricity markets, which can be broken down into energy or capacity markets. Energy markets are like pay-as-you-go plans, with energy producers paid only for the actual number of megawatts (instead of megabytes) delivered and used. On the other hand, capacity markets are like fixed data plans, with energy producers being paid a set fee to provide a certain number of megawatts, regardless of the amount generated or used.

Of course, things are more complicated than that, so let’s take a deep dive together to better understand the differences between the two, as well as their respective pros and cons.

What is a Capacity Market?

Let’s start with the simpler of the two options: capacity markets. These kinds of markets are more familiar to most people since they have historically been the way the energy sector was - and in many places still is - run. In a capacity market, energy producers are compensated for their ability (or capacity) to provide a predetermined amount of generation to the market. As such, capacity markets are primarily influenced by supply, rather than demand, as in energy-only markets (EOM). From an organizational perspective, capacity markets are more centralized, as opposed to more decentralized EOMs.

Specifically, for a capacity market to function, there needs to be a government-appointed entity to plan, approve, and administer capacity contracts. These contracts refer to the competitively auctioned contracts that private power generators bid on. For example, if a contract for 1000MW of capacity is up for auction, the private generator that offers the lowest asking price is awarded the contract. Having successfully bid for a contract, the generator’s fixed capital costs are paid by the government regulator, together with revenue from the spot market.

A capacity market encourages private generators to invest in new energy infrastructure, as controlling more capacity means more earning potential. Payments provide generators with income during the lengthy construction cycles typical of energy plants. Being paid for capacity offers the owners of expensive peaker plants (plants that may only be online a few hours a year) a steady revenue stream. By taking some risk out of capacity projects, a capacity market’s chief benefit is its ability to easily ensure ample capacity, both for future demand projections, as well as during Peak hours.

What is an Energy-Only Market (EOM)?

One of the drawbacks of a capacity market is that they often fall victim to generation oversupply, which can create severe financial and environmental consequences. A market with lots of excess capacity may have a sufficient buffer to ride out Peaks, but there can also be a lot of waste generated as a result. For example, coal and oil fired generation plants (the kind that can be rapidly deployed to combat Peaks) account for 26% of independent system operator ISO New England’s nameplate capacity. Still, these plants only produced 3 percent of that system’s total energy in 2017. This is clear evidence of capacity market incentives creating a glut of peaker plants.

In comparison, an EOM reduces overcapacity by changing the payment formula to only pay producers for the amount of energy delivered instead of their total potential deliverable energy (capacity). This reduces the incentive to over-invest in excess capacity, with EOMs instead rewarding those who innovate and find it easy to increase efficiency. For instance, producers who can speed up their capacity delivery (i.e. can respond to increased demand more quickly) can earn more money, as EOMs encourage generator flexibility: the more flexible you are, the more you can earn by responding to price developments on the power exchange.

EOMs rely on power traders trading via exchanges and signing bilateral commercial agreements rather than relying on a public sector body to centrally plan the market. Moreover, in an EOM, capacity is only indirectly compensated through implicit supply agreements like futures contracts. During periods of higher than usual demand, the electricity price increases on the power exchange, with power plants coming online to serve increasing demand based on the principle of merit order. Merit order is determined by a generator's marginal price, with the cheapest generators coming online first, followed by the next cheapest and so on, until as a last resort, Peak load assets (e.g. oil and gas peaker plants) come online, to sell electricity at very high prices.

[...] the more flexible you are, the more you can earn by responding to price developments on the power exchange.

At this point, one of the main criticisms of EOMs raises its head; namely, that market activity alone doesn’t provide the money required to expand reserve capacity. Power plants can take over a decade to complete, and unlike in a capacity market, producers in an EOM don’t receive any revenue from this ‘capacity in progress’. This is even more of a concern for peaker plants that only come online as a last resort: no capacity funding means little economic incentive for businesses to invest.

This is why a purely market-driven EOM exists only in theory. In practice, other supplementary measures need to be adopted. Firstly, there is something called a control reserve market, which refers to capacity that can be called upon very short notice to ensure network frequency (if the frequency is too high or low, connected equipment can not function or shut off). EOMs are also supplemented by capacity reserves established due to political or strategic considerations, such as ensuring national security or preventing excessive (and thus politically untenable) electricity prices.

Nevertheless, while this means that supply guarantees in EOMs are more complicated, they are also more efficient. Instead of relying on large scale generators with decade-long construction cycles, EOMs prioritize distributed and decentralized energy sources, which while smaller, are far quicker and cheaper to build. Collectively these distributed sources can provide the same kind of capacity as larger, legacy generators but are more flexible since they can be controlled individually.

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