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A Capacity Market that Makes Sense Peter Cramton & Steven Stoft 3 June 2005 Why a capacity market at all? Other industries don’t have one Price Short run Supply Long run E(Rent) = Fixed cost P* Inframarginal rent Demand Quantity 3 Why capacity market at all? • Market failure – Absence of demand response – Supplier market power especially in load pockets • Regulatory response – Prices are capped at $1000/MWh ($250 in California) – Supply offers are “mitigated” if much over MC (PJM: MC + 10% in load pockets) • Result – Generators cannot cover FC from energy revenues 4 Traditional ICAP Market Price Competitive = $0 price Demand True supply Quantity 5 Traditional ICAP Market Demand Price True supply Bid supply $999 Profit from exercise of market power Competitive = $0 price Quantity 6 Traditional ICAP Market • Pays based on “availability” • Available if you say you are, and there is no compelling evidence otherwise • Result – “Dog” plant gets large capacity payment • • • • • Slow start Extremely high marginal cost Never called (even in crisis) Always appears available Does not contribute to reliability 7 VOLL pricing: administrative price spike • Carrying costs paid by Price – Infra-marginal rents – Price spikes when short Infra-marginal rents Peakers: old / new Shoulder Base Variable Cost Quantity • Big enough price spikes reliability • Infra-marginal + spikes right generation mix • Problems – $15,000 price spikes due to weather / outages too risky – Spike payments too sensitive to over/under capacity – Too tempting for the exercise of market power 8 A Better Solution: Replace price spikes with LICAP • Eliminate the bad aspects of price spikes • Retain the good aspects 9 Replace price spike with LICAP Note extreme sensitivity to capacity level Price LICAP Demand Curve 2EBCC Price-Spike Revenue Curves EBCC Weather / outage risk, year-to-year fluctuation Target Capacity Capacity EBCC = expected benchmark carrying cost (annualized fixed cost of frame unit) 10 Four essential features • Eliminate market power in LICAP market • Eliminate incentive to create real-time shortages • Reward the reliable • Calibrate demand curve for desired reliability 11 1. Eliminate market power in LICAP market Price 2EBCC LICAP market clearing • Suppliers bid as they wish • Clearing price determined by actual capacity Supply offered EBCC Clearing Price Demand Capacity Criterion Target Actual EBCC = expected benchmark carrying cost (annualized fixed cost of frame unit) 12 2. Avoid incentive for real-time shortages • LICAP payment = LICAP Price – “Peak Energy Rent” • “Peak Energy Rent” = actual inframarginal energy rents of efficient benchmark peaker – – – – No incentive for supply to create real-time shortages Avoids controversy of estimating energy rents Reduced risk for suppliers and load Prevents supply from using threat of shortages to negotiate more favorable long-term contracts – Removes administrative shortage price from efficient long-term contracts 13 3. Reward the reliable • Available means “during shortage hours” • If 90% available during shortages, get 90% of full LICAP price – Shortage hours = insufficient operating reserves – Available = providing energy or reserves in shortage hours • Slow-start offline resources are deemed “unavailable,” because these resources could not capture price spike • Prevents high-cost inflexible resources from collecting LICAP • Load should not pay for “capacity” that cannot produce during a shortage—that capacity does not contribute to reliability • Availability smoothed to reduce risk 14 4. Calibrate for desired reliability 2.00 LICAP Price Installed Capacity Probability Density FCs or Events/Decade OC Loss of Load Probability 1.50 1.00 \ 0.50 0.00 0.900 0.950 1.000 1.050 1.100 1.150 1.200 Capacity / Objective Capability 15 Conclusion: It makes sense • Economic LICAP has these advantages: – Addresses market power (spot energy and LICAP) – Reduces profit risk lower cost – Incentive for efficient generation mix 16