A Capacity Market that Makes Sense Peter Cramton & Steven Stoft 18 March 2005

Why a capacity market at all?

3 Other industries don’t have one Quantity Supply Demand Price Inframarginal rent P* Short run Long run E(Rent) = Fixed cost

4 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

5 Traditional ICAP Market Quantity True supply Demand Price = $0 Competitive price

6 Traditional ICAP Market Quantity True supply Demand $999 Bid supply Price = $0 Competitive price Profit from exercise of market power

7 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

8 VOLL pricing: administrative price spike Price Quantity Carrying costs paid by –Infra-marginal rents –Price spikes when short Big enough price spikes  reliability Infra-marginal + spikes  right generation mix 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 Base Shoulder Variable Cost Infra-marginal rents Peakers: old / new

9 A Better Solution: Replace price spikes with LICAP Eliminate the bad aspects of price spikes Retain the good aspects

10 Price Capacity Replace price spike with LICAP Price-Spike Revenue Curves Note extreme sensitivity to capacity level Weather / outage risk, year-to-year fluctuation 2  EBCC EBCC Target Capacity EBCC = expected benchmark carrying cost (annualized fixed cost of frame unit) LICAP Demand Curve

11 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

12 Price Capacity Demand Clearing Price 1. Eliminate market power in LICAP market Supply offered Criterion Target Actual EBCC 2  EBCC LICAP market clearing Suppliers bid as they wish Clearing price determined by actual capacity EBCC = expected benchmark carrying cost (annualized fixed cost of frame unit)

13 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

14 3. Reward the reliable Availability 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

15 4. Calibrate for desired reliability

16 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

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