Energy Capacity Markets

Background

Several factors have prompted policymakers to open the conversation on generation adequacy and the need to introduce capacity markets in Europe: (i) the increased share of intermittent renewable energy in the energy mix of most member states, (ii) the effects of gradually phasing out conventional power plants following the implementation of the Large Combustion Plant Directive and the Industrial Emissions Directive, (iii) the nuclear phase-outs or restrictions to build new nuclear, and (iv) stricter standards for building new power. All these factors have caused conventional power plants difficulties in securing reasonable profitability, which in the longer term can seriously harm future investments needed to maintain a satisfactory level of security of supply. The increased capacities of intermittent renewable sources of energy have subsequently amplified the need for more back up reserves and flexibility available in a system.

To avoid the worst case scenario, where all these factors can potentially cause blackouts across Europe, it is imperative to address the issue of security of supply by incentivising the market participants to invest in new generation capacities.

The incentive takes the form of a mechanism called capacity remuneration, which aims to provide market participants with a stimulus in addition to the payments made available under an “energy-only” market. The capacity markets are meant to provide investors with a secure stream of revenue in the form of capacity remuneration that rewards the market participant not only for delivering energy into the system but also for being available to deliver when requested by the market operator.

In a perfect energy-only market without any market failures, the operating and capital costs of a power plant could be recovered exclusively through the market price, and there are no payments for capacity.

In November 2012 the EU Parliament’s Industry, Research and Energy Committee requested the Agency for the Cooperation of the Energy Regulators (ACER) to issue an opinion on capacity markets. ACER has issued both an opinion in February 2013 and a report in July 2013. The Commission is expected to also issue a communication on public intervention in the electricity sector, including on capacity markets.

Capacity remuneration mechanism

ACER underlines the fact that in an integrated European energy market security of supply cannot be just a national concern and should be addressed at the European, or at least regional, level. Currently there is no uniform approach of capacity remuneration across Europe, as the member states are pursuing a national generation adequacy policy. Finland, Greece, Ireland and Northern Ireland, Italy, Portugal, Spain, and Sweden have implemented capacity remunerations. Belgium, Denmark, France, Germany and Great Britain are considering introducing a capacity market. The rest of the member states have no capacity remuneration in place, nor are they considering introducing one soon.

Capacity remuneration can be volume-based or price-based. The volume based remuneration can be targeted; takes the form of strategic reserves or market-wide; and takes the form of capacity obligation, capacity auction, or reliability option. The price-based mechanism takes the form of a capacity payment.

Most of the capacity remunerations in place in the member states mentioned above are there to ensure generation adequacy but also to provide more flexibility and to reduce price risk and price volatility.

Risks associated with capacity markets

Given their purpose, capacity remunerations (besides creating an incentive for the market participants to invest in new generation capacities) can distort prices and cross-border competition, and in the long term can influence investment decisions in energy infrastructure (for example, creating less cross-border infrastructure or investing less in storage and demand side management) since the volume and price risks can be controlled via the capacity remuneration.

In its opinion to the parliament, ACER has underlined the fact that a capacity market should be implemented only when and to the extent that energy-only markets cannot provide sufficient incentives on their own for the investments that are needed, and they should have as little influence as possible on the energy markets.

ACER has proposed that prior to designing and implementing a certain type of capacity remuneration regionally or across Europe, at least the following matters must be first addressed: a common or regional approach for assessing the security of supply and generation adequacy level, and ensuring access to the security of supply and flexibility resources provided by generators in another member state.

Capacity markets should be introduced at least at a regional (if not European) level. They should be compatible with the electricity target model. And their design should prevent distortions to the functioning of the internal energy market and cross border trading. The introduction of national capacity markets should follow only after a sound and detailed impact assessment.

authors: Bernd Rajal, Raluca Dîrjan