Unlike other commodities, electricity cannot be easily stored in large quantities, meaning it must be generated the moment it is consumed. This technical constraint creates a profound economic challenge. Power companies must build and maintain expensive generation facilities that are only needed during the few hours of highest demand each year. Ensuring the grid can reliably meet demand, especially during extreme weather events or sudden equipment failures, requires a dedicated solution to incentivize this necessary reserve capacity.
Defining the Capacity Market
A capacity market is a mechanism designed to ensure a power system has sufficient resources to meet forecasted peak electricity demand plus a reserve margin for unexpected events. Power generators are paid for their commitment to be available, not for the actual electricity they produce. The primary goal is achieving resource adequacy: having enough generating capability to serve all customer load, even when facing unforeseen outages or higher-than-expected demand.
Capacity markets financially compensate power suppliers for the readiness to generate power when the grid operator calls upon them. This compensation is separate from the revenue earned by selling energy when the plant is actually running. This separate revenue stream encourages the construction and retention of power plants that might otherwise be uneconomical due to low operating hours. This commitment, typically secured years in advance, helps grid operators maintain a stable supply and prevent shortages.
Why Capacity Markets Are Necessary for Grid Reliability
Capacity markets were created to solve the “missing money problem.” This problem arises because competitive wholesale electricity markets, which pay generators based only on the energy they deliver, often fail to provide enough revenue to cover the high fixed costs of building and maintaining necessary power plants. Energy prices are often capped or depressed, preventing them from rising to the levels needed to incentivize sufficient investment in reserve capacity.
The volatility of peak demand exacerbates this issue. Generation assets needed only for a few hours a year—such as during a summer heatwave or a winter cold snap—cannot recover their investment costs solely through the energy market. Without capacity payments, these generators would retire early, or new ones would not be built, leaving the system vulnerable to blackouts during stress events. Capacity markets provide the stable, long-term revenue stream required to justify the investment in these reserve resources, ensuring they are available for critical moments. This mechanism ensures the system maintains a planning reserve margin, which is the extra cushion of generating capacity needed for reliability.
The Mechanics of Capacity Market Auctions
Capacity is typically bought and sold through a competitive auction process managed by the regional grid operator. These are generally held as “forward auctions,” meaning capacity is procured several years in advance of the actual delivery year. Procuring capacity three or more years ahead provides the necessary lead time for new power plants to be constructed or for existing facilities to secure financing.
The auction process begins with the grid operator forecasting the total capacity required to meet the region’s expected peak demand and reliability standards. Generators and other resource providers then submit bids indicating the price at which they will commit their capacity. The operator accepts bids starting from the lowest price until the total required capacity is met, establishing a single “clearing price” paid to all successful bidders.
Who Participates in the Auctions
A diverse set of resources competes in the capacity market auctions to provide the necessary reliability. These include traditional fossil fuel and nuclear power plants, which offer firm, dispatchable power. Non-traditional resources also play a significant role, such as energy storage facilities.
Demand response programs are another major participant, where large electricity consumers are paid to reduce their energy use during system stress events instead of a generator increasing output. All these resources compete directly against each other, regardless of their technology, to offer the lowest-cost solution for meeting the grid’s reliability needs.
Understanding Capacity Obligations
When a resource wins a bid in the auction, it takes on a contractual “capacity obligation” to be available to provide power or reduce load when called upon during the delivery year. This obligation is a commitment to be ready to perform during a grid emergency.
To enforce reliability, the capacity obligation is backed by a system of financial penalties. If a committed resource fails to perform or is unavailable during a system stress event, it faces a financial penalty. This mechanism ensures that only reliable resources bid into the market and reinforces the commitment to grid reliability.
Capacity Markets Versus Energy Markets
The distinction between capacity markets and energy markets is fundamental, as they trade two different products. The energy market is where the actual physical commodity, electricity, is bought and sold in real-time. Generators earn revenue in the energy market based on the quantity of electricity they produce and deliver to the grid.
The capacity market, conversely, trades in the promise of power—the resource’s ability to generate electricity. This market provides a payment for the power plant’s fixed costs and its availability, irrespective of whether it actually runs. A generator’s total revenue stream often depends on earning income from both the energy market (for power produced) and the capacity market (for power availability) simultaneously.
The Economic Impact and Ongoing Debate
The cost of capacity markets is experienced by consumers through a component of their utility bill known as the capacity charge. This charge represents the cost of payments made to generators and is the price paid for ensuring grid reliability. Proponents argue that this cost is an efficient way to maintain long-term investment in the system and prevent the greater economic cost of widespread blackouts.
Despite their role in reliability, capacity markets are the subject of ongoing debate and criticism. Critics argue that the markets can distort investment by over-procuring capacity, leading to higher costs for consumers. They also contend that the payments can favor older, less efficient generation facilities, providing them with a lifeline that prevents their retirement.
The debate also centers on the market’s role in the energy transition. Proponents assert that capacity markets are adaptable, ensuring that intermittent renewable sources and energy storage are valued for their reliability contribution. Conversely, critics worry that by subsidizing existing, often carbon-intensive, resources, the market may slow the shift toward a cleaner, more flexible power system.