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Capacity Markets

Written by
Tomás Oliveira

Capacity markets are specialised mechanisms within the broader electricity markets designed to ensure that there is a sufficient power supply to meet future demand. 

3 min
25th May, 2024
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These markets operate by providing financial incentives to electricity generators and other resources to maintain and, if necessary, expand their production capabilities, ensuring grid reliability and stability. 

The importance of capacity markets lies in their role in mitigating the risk of blackouts and power shortages, which can have significant economic and societal impacts. This function is increasingly critical as the integration of renewable energy sources, such as wind and solar, introduces greater intermittency and unpredictability in power generation.

 

How do Capacity Markets work?

They operate alongside other electricity markets like wholesale energy markets (where electricity is bought and sold for immediate delivery) and ancillary services markets (which ensure grid stability and reliability). 

Here’s a breakdown of their operations:

 

Forecasting demand

Grid operators or regulators forecast the future electricity demand, often looking several years ahead, to determine how much capacity will be needed.

 

Setting requirements

Based on these forecasts, the amount of capacity required is set. This is often done through a process known as a capacity auction.

 

Capacity auctions

In a capacity auction, power generators and other capacity providers (such as demand response providers) bid to offer their capacity for a future period. The bids are typically ranked by price, and the lowest-cost options are selected until the required capacity is met.

 

Payments to capacity providers

Successful bidders receive payments for committing to be available to provide power (or reduce demand) during the specified future period. These payments help cover the fixed costs of maintaining and operating power plants, ensuring they are ready when needed.

 

Compliance and penalties

Capacity providers are obligated to be available during the agreed period. If they fail to meet their commitments, they may face penalties.

 

Types of Capacity Markets


Centralised Capacity Markets

It operates on an auction system where producers are compensated for maintaining available capacity, overseen by a central entity like the grid operator.

Decentralised Capacity Markets

This system permits bilateral contracts or dedicated markets, providing flexibility and adaptability to meet the specific needs of market participants.

 

Challenges in Capacity Markets


Cost

Capacity payments are an additional cost that is ultimately borne by consumers.

 

Market complexity

Designing and operating capacity markets can be complex, requiring sophisticated forecasting and auction mechanisms.

 

Overcapacity

There is a risk of procuring more capacity than needed, leading to inefficiencies and higher costs.

 

By guaranteeing that there is always enough reserve capacity to handle peak loads, unexpected surges in demand, and the variable output of renewables, capacity markets help to balance supply and demand, fostering a secure and resilient energy system.

Reach out to our Advisory team to get a better understanding of how capacity markets should be accounted for when structuring a PPA.

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