Capacity Markets

Question

An electricity grid already has an energy market where power is bought and sold. Why would a grid operator run a separate "capacity market" on top of it, and what problem does that capacity market solve?

Accepted Answer

Let's first separate the two markets, because the whole answer hinges on the difference.

The energy market pays you for electricity you actually produce. Generators offer power, and the price settles at the cost of the most expensive plant needed to meet demand in that moment — this is called the marginal cost, the cost of producing one more unit. To make this concrete, suppose at 7pm the grid needs 100 units of power. Plants bid in from cheapest to most expensive, and the last (most expensive) plant called on to hit 100 units bids 60 dollars per MWh. Then everyone who cleared gets paid that 60 dollars per MWh — the marginal price sets the price for all. A MWh (megawatt-hour) is just a unit of electrical energy: the amount a 1 MW plant makes in one hour.

Here's the problem this creates. A plant that only runs on the few hottest or coldest days of the year — a "peaker" — might be needed for just 50 hours out of the 8,760 hours in a year. The energy market alone pays it almost nothing the rest of the time, so its owner can't cover the cost of keeping it built and maintained, and may simply shut it down. But on the single worst day of the year, when an unexpected cold snap spikes demand and a big plant trips offline, you desperately need that peaker to exist. An energy-only market underpays for being available, so you end up with too little spare capacity exactly when you can least afford a blackout.

The capacity market fixes this by paying generators (and demand-side participants who agree to switch off on command) simply for being available to deliver in the future, whether or not they actually run. The grid operator forecasts peak demand a few years out, adds a safety buffer, and then buys commitments — typically in an auction — for that much standby capacity. A plant that wins a commitment receives a steady payment for promising "I will be there and ready when you call." If it then fails to show up when needed, it gets penalised. So the energy market rewards producing power, and the capacity market rewards standing ready to produce it.

Let's put a number on why this matters to an investor. Say a peaker costs 90,000 dollars per MW each year just to keep alive (maintenance, staff, financing). From the energy market it scrapes together maybe 50,000 dollars per MW per year, because it runs so rarely. That leaves a hole:

\begin{equation} 90{,}000 - 50{,}000 = 40{,}000 	ext{ per MW per year} \end{equation}

If the capacity market pays at least 40,000 dollars per MW per year, the plant breaks even and stays open. Without that payment it shuts, and the grid loses a unit it needed for emergencies.

Sanity check
Does the capacity payment cover the gap? Add the two revenue streams together and compare to the cost:

\begin{equation} 50{,}000 + 40{,}000 = 90{,}000 = 	ext{annual cost} \end{equation}

The plant exactly covers its costs, so it rationally stays available — which is precisely the outcome the grid operator wanted to buy. Good, the logic holds.

So the two markets complement each other cleanly:

 	Reliabilitythe energy market dispatches power efficiently moment to moment, while the capacity market guarantees enough plants exist to cover the rare peak so you don't run short.
 	Investment signalthe energy market gives volatile short-term prices, while the capacity market gives a steady, predictable revenue stream that makes a multi-year investment in a new plant bankable.
 	Price stabilityby ensuring spare capacity exists, the capacity market reduces the chance of those extreme scarcity spikes where the energy price rockets because there simply isn't enough supply.
 	Renewables backupwind and solar are intermittent — they vanish when the wind drops or the sun sets — so the capacity market is a tidy way to pay for the flexible backup generation that has to be on standby to cover those gaps.


So the capacity market isn't a competitor to the energy market — it's the insurance policy that keeps the lights on when the energy market alone would have let your spare plants disappear!

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Capacity Markets

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