Reforming capacity markets : how to incorporate the flexibility of residential consumers?

This paper analyses capacity markets and proposes an approach to incorporate the flexibility of residential consumers in these markets considering reliability as a differentiated product. We introduce and assess the potential of non-linear pricing schemes, specifically priority pricing contracts, as mechanisms to enhance implicit residential demand response. We suggest a model to integrate priority pricing contracts via an aggregator as explicit demand response in capacity markets, advocating for participation on the ‘demand’ side rather than the ‘supply’ side to prevent market distortion and better align with consumer reliability preferences. To incorporate these contracts into the capacity demand curve, we examine the correlation between capacity and reliability, establishing that under ideal conditions, the marginal cost of outages aligns with the marginal cost of capacity, thus linking capacity to the value of lost load and loss of load expectations. This connection informs the design of the capacity demand curve using data from priority pricing contracts. We demonstrated this approach using the 2027-28 UK capacity market, and also introduced a refined capacity product for trading in capacity markets, designed to encourage investment in demand response resources and incorporating specifics about location, flexibility, and adjustments to the calculation of firm capacity profile. Lastly, we propose a potential business model for the aggregator that leverages residential demand response that does not create distortions in the retail market.