EI-FACTSHEET 2013-03 1

CAPACITY MECHANISMS
Electricity markets are facing major challenges in Europe, mainly influence on the remuneration of base and mid load power
driven by the ambitious European climate and energy targets. plants. The load factor of these plants is reduced and the
While the electricity generation mix must change, the current number of operating hours is not sufficient to cover the fixed
market design might not sufficiently facilitate this change. So far, and maintenance costs.
generation was mainly based on large centralized and
controllable power plants. However, increased generation from The present situation in Belgium concerning generation capacity
intermittent Renewable Energy Sources (RES) affects the energy is contradictory (see Fig.1). During peak demand periods
market, potentially endangering future security of supply (winter 2012/2013), more electricity than ever was imported
including short-term reliability and long-term system adequacy from neighboring countries. It amounted to a net electricity
(see EI Fact Sheet2013/02). import of 5564 GWh (Nov 2012-Feb 2013). At certain periods,
the total import capacity of 3500 MW was fully utilized to cover
System adequacy can be achieved by increasing interconnectivity generation shortages in Belgium. The shortage of generation was
with neighboring countries or by improving generation adequacy. caused by the outage and the overhaul of the nuclear generation
Interconnectivity is important for balancing the volatility of RES. units Doel 3 and Tihange 2, respectively 1006 and 1008 MW
However, this fact sheet focuses on the possible improvement of (light blue). Permanent shut downs of power plants in Ruien
generation adequacy through capacity mechanisms. (Coal) and Vilvoorde, restriction of output in Zandvliet (both
CCGT) (light brown) further increased the unavailable
The need for flexible generation capacity to balance RES and generation capacity to a total of 3127 MW.
demand variability has risen and must be addressed by the
market design. The contradictory situation of shutting down existing power
plants while facing an increased need for flexible units to cover
These challenges are also addressed by the Belgian Plan intermittent generation from RES has to be addressed.
Wathelet (June 2012, approved by the inner cabinet in July 2013)
issued by the Secretary of State in charge of Environment, Existing power plants must be able to provide their capacity at a
Energy and Mobility. This plan discusses both the need to ensure profitable level while also new investments are to be incentivized.
generation adequacy as well as generation flexibility in the A recently proposed scheme provides a subsidy of 87682.10 €
transition period towards more RES. per MW and per year for new installed gas-fired power plants
during the first ten years. However, if existing power plants
cannot run profitably and are being shut down, subsidizing new
Situation in Belgium installations does not improve the situation but destroys existing
asset.
Currently, the Belgian electricity market is organized as an
energy-only market, henceforth referred to as energy market.
Generators are remunerated for the energy sold to the
market (typically expressed in €/MWh during a specific period).
In theory, assuming perfect competition, the price for electricity
is determined by the equilibrium of supply and demand equal
to variable generation cost of the marginal generating unit. Base
and mid load units with relatively low variable costs realize an
inframarginal rent when a peak load unit with higher variable
costs is market clearing. Inframarginal rents are needed to
recover fixed generation costs and expected to trigger new
Fig.1: Generation adequacy of base and exible generation for Belgium
investments ensuring generation adequacy. Also during moments
of scarcity, electricity prices may rise above the variable cost of
peak load units. In this case inframarginal rents are also referred Capacity mechanisms
to as scarcity rents.
A situation where prices for generating electricity are not
Many RES are offered at low or zero marginal costs to the high enough in time of peak demand to recover fixed costs of
market, resulting in low, sometimes zero or even negative prices, existing power plants and incentivize adequate new investments
the zero and negative ones mainly driven by guaranteed green is described as the missing money problem. Capacity mechanisms,
certificate prices. Consequently, large scale generation of RES if designed and implemented properly, could be one way to
reduces the market clearing electricity price, having a negative address this impediment that might result from the energy-only

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market structure. Capacity mechanisms are additional are the price-based mechanism capacity payments as well as
mechanisms influencing the volume of installed generation the quantity-based mechanisms strategic reserves, capacity
capacity to ensure short-term reliability and long-term requirements and reliability contracts. A condensed overview of
generation adequacy. the key properties is given in figure 7, towards the end of this
fact sheet.
Although different mechanisms exist, the principle is equal for all
capacity mechanisms. The mechanism replaces the investment Capacity payments
incentives of price spikes with a more steady incentive. It
generates an additional revenue stream, valuing the installed Capacity payments are direct payments from an authority to
capacity of a generation unit, in addition to the existing one for all generators according to the installed or available capacity.
energy. The payments generate a flat revenue stream for the
generators independent of the generated electricity but
The desired outcome of capacity mechanisms is to ensure proportional to the capacity made available (typically expressed
security of supply and to resolve potential problems emerging in €/kW). The payment is estimated by the authority and may
from market malfunctioning. Generating companies could vary with the technology, the definition of availability or the total
benefit from the reduced dependency on peaking price levels amount of installed capacity for each generating unit. The costs
for generated energy. This helps to mitigate the problems are socialized among all consumers in form of taxes or capacity
arising from the increased volatile generation of RES. Further- surcharges.
more, the additional revenue stream reduces investment risks for
the back-up plants. The resulting generation mix allows balancing Figure 3 shows the electricity demand curves for an average
the fluctuations of RES in the short-term and is able to meet (Da) and a peak demand (Dp) at a particular moment in time.
growing peak demand in the long-term. With the reference supply curve (S), the peak demand shown
cannot be supplied. Through capacity payments new investments
Categorization of capacity mechanisms are incentivized which leads to an extended supply curve S* in
the long run.
Capacity mechanisms are categorized into two main groups:
price-based and quantity-based. Advantages: Capacity payments are an easy to implement
incentive for new investments. They reduce the investment risk
of the generators and stimulate investments in new generation
capacity. The cost for the risk reduction is defrayed by all
consumers independent of their demand. Moreover, the
authority can support desired technologies through specific
payment levels. This way, the quality of capacity can be directly
rewarded, i.e. more reliable capacity is remunerated higher while
intermittent RES are excluded from the payments. Once
capacity payments become redundant, they can be phased out
easily.
Fig.2: Categorization of capacity mechanisms

Price-based mechanisms drive investment by providing direct

financial support for investment. The structure of these
incentives determines the resulting installed capacity whereby
the prediction of the response of investors is crucial for its
success. This is a complicated matter, requiring detailed
knowledge of the market. Therefore, a wrong estimate can easily
cause undesired under- or overinvestment.

Alternatively, in quantity-based mechanisms a regulating authority Fig.3: Capacity payments leading to an extended supply curve
sets a desired amount of installed capacity and the price evolves
from the market clearing. In this way the amount of installed Disadvantages: The level of capacity payments depends on the
capacity can be controlled and ensured directly by the authority. assumption on future demand and the investment response to
the payments. The level of payment is only set by the
In both approaches sufficient number of parameters should be authority and therefore subject to political decision making. This
left to the market to achieve an optimal volume of capacity in an can lead to unexpected investment behavior and adjustments of
economically efficient way. the mechanism might be necessary. These adjustments influence
in turn the investment risk. Furthermore, if capacity payments
In what follows, examples of each group are presented. These are paid for existing installed capacity (to avoid premature

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closure), “established” generating companies already present in Advantages: If the energy-only market proves efficient
the market, are given a competitive edge. This could impede new concerning triggering investment, the activation of the strategic
market entries. Finally, the authority collects the charges from all reserves is kept at a minimum level. In fact, for the integration
consumers. Thus, the cost for risk reduction is spread on all of strategic reserves, only small changes to the existing market
consumers based on an additional charge. It can be flat or and the regulatory situation are needed. The flexibility of the
consumption-dependent. A variable charge would value each reserve with regard to volume and range of application in both
consumer’s contribution to the demand of capacity. In contrast, a directions leaves the control with the system operator. In case
flat charge scheme allows consumers with mainly consumption the strategic reserve turns out to be redundant, it can be phased
in the peak hours to benefit from other consumers. Capacity out again.
payments are implemented in Spain and Portugal to attract
flexible generation to backup RES as well as in some South- Disadvantages: The setting of the fixed price for the activation
American countries to attract new market players. of the strategic reserve is crucial for the volume of investments.
With incorrect price setting, the price acts as a price cap to
Strategic reserve the market which impedes additional investments. Also, accurate
predictions about the price-duration and load-duration are
The strategic reserve is an amount of emergency capacity (Csr ) necessary to set the price pr without distorting the market
held by the system operator in charge. The strategic reserve significantly. Moreover, a strategic reserve does not sufficiently
mostly consists of old units purchased or contracted from the address the price volatility and risk of investment for peak power
generating companies, but it can also include newly built units. plants resulting from increased injection of RES. It only solves the
The costs of contracting this reserve are recovered by an need for an adequate generation capacity to cover peak demand.
additional charge for consumers comparable to use of system
charges. In Sweden, Norway and Finland a strategic reserve is implemented.
It is proposed for Belgium in the Plan Wathelet and it is also
The system operator should be strictly neutral to the market being discussed in Germany.
and only start up the reserve in case of scarcity; in other words,
the system operator deploys the strategic reserve at risk of Capacity requirements
shortage of electricity. It extends the supply curve (S) in figure 4
with a perfectly price-elastic (horizontal supply) section to cover Capacity requirements are an example of a quantity-based
peak demand (Dp). mechanism. An additional market for generation capacity is
created. By means of capacity credits, the required peak capacity
Either, as soon as the difference between demand and supply is is being traded between generating units and retailers (see right
critical the capacity from the strategic reserve is offered to the side of figure 5).The demand curve of capacity (Dcc) is fixed as
market. Or, as soon as the market price for electricity reaches a downward curve around the fixed point of targeted installed
a certain price limit, the electricity is offered to the market. The capacity plus reserve margin (Cr ) and the estimated costs of
generated electricity is then sold to the market at a fixed price new peak power plants (pr [€/MW]).
(psr ). This price is determined upfront and influences the
investments in capacity. The supply curve in the capacity market is constructed by the
aggregation of generating companies offering their peak capacity.
To prevent influencing the market, the price must be at least Capacity can take the form of generation capacity or
as high as the highest bid in the market. Above that, a higher interruptible load. Depending on the volume offered (Scc or Scc*
price (psr ) results in a larger incentive to invest in capacity by with lead time), the price for the capacity credits varies between
generating companies. a fixed cap (pm) and zero. The price paid for the capacity credits
pcc results in an additional revenue stream for the generating
companies. This incentivizes new investments shifting the
supply curve in the energy market (S*) to the right. The retailers
are obliged to buy capacity credits according to their expected
coincident peak demand of their final consumers. The price for
the capacity credits is forwarded by the retailers to their final
consumers.

A low price cap (pcap) avoiding price spikes in the energy

market, protects consumers from paying double for the installed
capacity. In any case, the reliability of the offered capacity and
Fig.4: Strategic reserve Csr leads to an extended supply curve its contribution in times of scarcity has to be controlled by the
system operator.

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option. Normally, when the electricity price is high all generating

companies are producing which leaves them with the revenues
from the strike price. As a result, producing companies have a
reduced income depending on the strike price. Generating
companies that sold options but are not producing when the
option is called have a net loss of the difference between spike
and electricity price. This is considered a fee for not contributing
to the security of supply as predicted.

Fig.5: Energy market and capacity market in a combined system The costs for the call options are partly recovered by the
differences paid by the generators and are partly socialized among
Advantages: Capacity requirements ensure the correct amount all consumers in form of taxes or capacity surcharges. Reliability
of generation capacity by directly controlling it via the set amount contracts result in a price cap for the consumers at the strike
of traded capacity credits. Because of the lead time of this price (ps). The expected price spike revenues for the generators
mechanism, the market for capacity credits becomes constrained are represented in the price for the options. In a well operating
before the energy market. This means that new investments are system, the costs for the options should be offset by the reduction
triggered before the security of supply is jeopardized. of price spikes, in other words a zero-sum-game.

Disadvantages: The effort for implementing and administrating a

second market is required. This includes the administration and
control of supply and demand. The additional introduction of the
capacity credits requires tracking and verifying their equivalent in
installed capacity. This check also includes the actual contribution
to reliability and adequacy during peak demand which is not trivial.

A market for capacity requirements exists in North America in

the PJM region and the New York Power Pool.
Fig.6: Reliability contracts in energy market and contract auction
Reliability contracts Advantages: Reliability contracts give a strong incentive to
generating companies to make power plants available in time
Reliability contracts are an enhancement of capacity requirements of scarcity. The net loss, resulting from not producing in time of
described above. Reliability contracts are a quantity-based scarcity, discourages to keep units from producing to manipulate
mechanism implementing an additional market for capacity in prices. Moreover, each generating company offers the volume
addition to the energy market. Reliability contracts are based of options based on their own expectation of the reliability of
on call options bought by a system operator from generating their power plants. The evaluation and control is shifted from the
companies. system operator to the generating company and gives an
additional incentive to keep the power plants in an available status.
The call options are auctioned at the beginning of a planning Because price volatility by cutting price spikes.
period. The system operator sets the volume of options and the
strike price.The volume of options represents the forecasted peak Disadvantages: As for capacity requirements a second market has
demand plus a reserve margin (in MW). The auction can be done to be established. However, as only a single buyer purchases the
with consideration of a lead time of projects (Drc*) or without call options on behalf of all consumers the administrative burden
(D rc). The strike price of the options is set above the highest is limited. A system of reliability contracts has not been installed
marginal costs in order not to push generators out of the market. yet. Hence there is a lack of experience. The determination of the
The price for the options itself is determined during an auction strike price and the total volume of call options have to be done
where generating companies offer their capacity (Src). If the by the system operator based upon estimations of the
auction is done with a lead time of several years, also planned development of peak demand. The setting of the strike price is a
but not yet installed generating units can participate (Src*). For trade-off between price stabilization and incentive for demand to
generators the auction of reliability contracts offers a secondary respond to spike prices. As already said, reliability options have not
steady revenue stream. been implemented so far.

In operation, a price in the energy market below the strike Implementation of capacity mechanisms
price induces no changes. In case the price in the energy market
(pelec) rises above the strike price (ps) the system operator calls In summary, it can be stated that capacity mechanisms are
the option. Hence, the generating companies who have sold an additional tools to ensure generation adequacy and security
option are obliged to pay the difference between the of supply by ensuring a steady income stream for generating
electricity and the strike price to the system operator for each companies. However, there is no definite opinion whether a

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capacity mechanism is actually needed or whether generation

adequacy can be achieved through market signals from an energy- Capacity mechanisms (lessons learned):
only market. Caution is needed for unavoidable “feedback
mechanisms” that exist in all real systems, since that may lead to • Energy-only markets can result in a missing money
unexpected situations. Therefore scenario exercises may be a problem, and therefore fail to incentivize
good way to anticipate answers to “what-if ” questions. It should • investments in generation capacity up to an adequate
be noted that capacity mechanisms are an additional regulatory level;
intervention in energy markets and require a political setting of • Increased volatile generation from RES challenges
price or quantity. This entails the risk of opening up capacity generating companies to operate profitably;
mechanisms to bargaining and lobbying for all involved • An additional capacity remuneration scheme appears as
stakeholders. subject of discussion in several European countries;
• Capacity mechanisms are:
Once decided on the need, within the range of the presented • market adjustments to reduce investment risk by
mechanisms, there is no final agreement in the literature on a ensuring steady revenue streams;
preferable mechanism. This is also represented in the wide • either price-based or quantity-based mechanisms
range of implemented capacity mechanism in different electricity with direct or indirect revenue streams;
markets. The mechanisms range from a simple and transparent • a regulatory intervention in the energy market
but regulatory payment to a market based approach which comes and may lead to market distortions if not properly
with a greater administrative burden of implementing new configured.
markets.

After taking the decision on the appropriate mechanism, it is also

a question on which level a capacity mechanism is applied; national
or EU-wide. In view of the common goal to establish an integrated
European energy market, capacity mechanisms are studied within
a divided national approach as well as within a future integrated
market. However, this can lead to a patchwork of capacity
mechanisms with varying interactions and investments shifted
towards countries with a more attractive capacity mechanism. As
long as the long-term process of establishing an integrated energy
market has not been completed, capacity mechanisms can play a
role in ensuring generation adequacy on a national level with its
specific generation mix and amount of RES.

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KU Leuven Energy Institute EI Fact sheet Capacity Mechanisms