Explainer: How Capacity Markets Work

Introduction

• Difference between Energy and Capacity: Both are crucial for maintaining the electrical system.
  • Energy: The electricity consumed and paid for by consumers.
  • Capacity: Forward-looking investments ensuring availability of power in the future.

What is a Capacity Market?

• Purpose: To direct investment and ensure power at a future date.
• Function:
  • Power plants receive compensation for promised future power delivery.
  • PJM Territory Example:
    • Base Residual Auction: Held annually with delivery three years later.
    • Incremental Auctions: Occur to balance commitments and manage unexpected changes.
• Power and Demand-side Resources: Both can bid into the auction (e.g., power plants, efficiency measures).

How Do Capacity Markets Work?

• Bidding Process:

  • Cost of Operation: Determines bid price (older plants might bid lower).
  • Auction Process:
    • Grid operators project demand (including a capacity margin) and hold auctions.
    • Resources bid their capacity, sorted from lowest to highest cost.
    • Clearing Price: Set by the most expensive unit needed; all resources receive this price.

• Example:

  • Grid needs 550 MW (hypothetical).
  • Bids from different resources (e.g., wind turbine, coal plant) are evaluated.
  • The clearing price is determined by the last resource needed to meet demand.

Implications and Dynamics

• Price Dynamics:
  • Lower-cost resources suppress overall market prices.
  • Higher-cost generation can be displaced by efficiency or lower-cost resources.
• Market Outcomes:
  • Consumers benefit from lower prices.
  • Utilities with costly generation view lower prices as negative.

Importance of Capacity Markets

• Role in the Future Energy System: They influence investment in diverse energy assets.
• Market Criticisms and Opportunities: Potential for detailed exploration in how they function and their effectiveness.

Conclusion

• Capacity markets are essential for directing future investments in energy resources, ensuring reliability, and potentially reducing costs for consumers.

Note: The author of the article is Adam James, a Research Assistant for Energy Policy at the Center for American Progress.