Markets & Policies

Electricity market design: do we need capacity mechanisms?

One of the latest publications from the Oxford Institute for Energy Studies (OIES) casts some doubts about the need and implementation of centralised capacity mechanisms proposing an alternative solution to complement the energy-only markets. At EU level the discussion about the introduction of capacity mechanism has a long story, and the EC is not completely favourable to them.

Electricity market design: do we need capacity mechanisms?

Within the power sector the discussion about introducing some kind of capacity mechanisms has been ongoing for many years. They are meant to complement the energy-only market to support the reliability and security of supply in the context of the radical changes that the power sector is facing.

The current situation according to OIES…

The recent OIES publication about market design highlights the many possible issues with the implementation of capacity mechanisms.

Energy-only markets under the current regulation design tend to be ineffective to provide in a timely manner and maintain over time electric system reliability and security. The two main challenges to energy-only market design are:

  • the possibility of a disordered and quick withdrawal from the market of flexibly dispatchable capacity (namely fossil fuelled power plants, which are squeezed out of the market by renewables);
  • the existence of market aspects that can distort electricity pricing signal for energy scarcity (the pricing signal is not clear and transparent due to market failures and other conditions).

A variety of (capacity) mechanisms have been implemented all over the world to address the risks of shortfalls in system reliability and security, and many of them involve a central party making decisions or setting parameters.

A key issue for the designed central authority is incorporating consumer preferences in decision making: the same level of reliability/security is provided to all consumers and reliability and security are assumed to be quasi-public goods. But the availability of distributed energy sources challenged this assumption at least for the reliability aspects. The market design should let the consumers to exercise choice and ensure that their preferences for reliability are reflected in the market.

… and a possible solution

To overcome the challenge of centralized capacity mechanisms the OIES proposes the “insurer-of-last-resort model” which would allow consumers to set preferences for reliability. A commercially mandated central authority would offer insurance coverage, and consumers decide whether and at what level of coverage to participate. Consumers pay premiums based on the level of coverage, and if a reliability lost-load event occurs, they get a compensation based on that coverage level.

Capacity mechanisms in the EU

Some months ago the European Commission approved six electricity capacity mechanisms in six different European Countries: Belgium, France, Germany, Greece, Italy and Poland[1]. At European level the main issue is to comply with the EU State aid rules. The objective is to ensure that the mechanisms (and their related incentives) will not unduly distort competition between market players, different technologies and countries in the liberalised EU’s internal energy market.

According to the EC, the eventual introduction of a capacity market (or mechanisms with similar purposes) should be made in parallel with reforms that can help to overcome market and regulatory failures of the current energy-only markets. Those reforms (such as the removal of low electricity price caps and enabling the participation of demand response) are already included in the Clean Energy for All Europeans Package proposals, and they are seen by the EC as fundamental bricks to build the power system of the future.

So… do we want capacity mechanisms?

Coal and nuclear phase-out policies coupled with an increasing share of intermittent renewable generation are challenging the power systems and the electricity market design, calling for a complete update of the rules of the game. The general idea is that capacity mechanisms are just a temporary solution for some of the rising issues before a comprehensive market reform.

But even if they are planned for a limited time span, they introduce some distortions in the market and they might not be as effective as hoped. And they look more and more like what they really are: a way to patch up the power market’s flaws. So the question remains open, as well as the quest for viable alternatives while planning an extensive reform.

[1] Strategic reserves for Belgium and Germany, market-wide capacity mechanisms for Italy and Poland, demand response schemes for France and Greece. In the last few years the Commission also approved market-wide capacity mechanisms in Great Britain, France and for the Irish ‘all-island’ market, and a specific demand response support scheme in Germany in 2016.

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