A Capacity Market that Makes Sense

We argue that a capacity market is needed in most restructured electricitymarkets, and present a design that avoids problems found in the early capacitymarkets. The proposed market only rewards capacity that contributes toreliability as demonstrated by its performance during hours in which there is ashortage of operating reserves. The capacity price responds to marketconditions, increasing when and where capacity is scarce and decreasing to zerowhen and where it is plentiful. Market power in the capacity market is addressedby basing the capacity price on actual capacity, rather than bid capacity, sogenerators cannot increase the capacity price by withholding supply. Actualpeak energy rents (the short-run energy and reserve profits of a benchmarkpeaking unit) are subtracted from the capacity price. This allows the capacitymarket to more accurately control short-run profits and suppresses market powerin the energy market. This design both avoids and hedges energy market risk,and by suppressing market power avoids regulatory risk. Risk reduction savesconsumers money as do the performance and investment incentives inherent inthe pay-for-performance mechanism.