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Capacity Markets: A Bridge to Recovery? A review of the ongoing evolution of market design. BY CRAIG HART ICAP, ICAP, UCAP, NoCAP. Some markets have them, some don't. Where they do exist, no two are equal. California was built without one, as were the markets of Australia and New Zealand. Northeastern U.S. markets all have them, albeit in slightly different variations. MISO will start one of the biggest energy markets in the world without one. PJM, long considered the model market, is debating a major over- haul to its current scheme. Others are considering such changes as well. As the experimentation with whole- sale energy market deregulation contin- ues, anevolutionary trend in capacity market design is becoming apparent in the United States. Most critics now support the conclusion that en re~gy only schemes in price-capped markets do not provide sufficient revenues to rn uce new generation and keep sys- tem-critical, high-cost generation resources in the market. As such, it is likely only a matter of time before energy on y mar ets are extinct. ut, w i e it appears at capacity markets are here to stay, there is little consensus regarding the best design. Markets in the United States are in a state of flux, with debate raging over many different capacity market pricing schemes. The pool-wide, single-price capacity market model utilized by PJM and others now appears too simplistic. New designs are calling for ever-more complicated structures aimed at fine-tuning the location, the timing, and the type of generation resources that capacity markets induce. While the winning recipe has yet to be selected, it is likely that participants in certain markets will witness signifi- cantchanges. In certain load pockets, generators could see a meaningful increase in gross margins if a pricing scheme that compensates generators based on location is adopted. Flexible units may receive an additional bump if changes being considered in PJM are adopted. But, these shifts are likely only to persist in the shoe to medium term. While providing a much needed bridge to market recovery For some, if the mar- kets function properly, price differentials should dissipate over time and bring long-term pricing back to the mean. Background Capacity markets are designed to ensure resource adequary. While various defi- nitions exist, resource adequacy gener- ally refers to the sufficiency of generation resources to meet the peak energy needs and maintain the stability of an electric system. In a traditional, regulated utility world, generation plants are added after resource planners determine the amount of new capacity that will be needed over the coming years to meet demand. While they are determining the actual amount of total installed capacity necessary to ensure resource adequary, resource planners also attempt to optimize the type of capacity that is built in terms of fuel type, technology, and market segment (i. e., baseload, intermediate and peaking). In this way, the best generation mix necessary to meet peak demand is determined through a central planning process. In a deregulated world, the decision to build new capacity is made by indi- vidual market participants instead of through a central planning process. The underlying question becomes how to design a market to properly incen- tivize profit-maximizing participants to develop enough generation capacity to ensure resource adequacy As the theory goes, the answer is that the market must provide adequate compensation so that a new entrant is able to earn rev- enues that are high enough to cover costs and earn a fair return. 74vo Basic Models There are essentially two schools of thought when it comes to designing markets that provide adequate revenues to generators: energy only (referred to as "NoCAP") and energy-plus- capacirymarkets.' Many have followed the NoCAP route. In the United States, California, ERCOT, and MISO started without an explicit capacity market. Australia and New Zealand, as well as the markets in Ontario, Alberta and Scandinavia (NORDPOOL) all have functioned without a formal capacity support mechanism. The general belief (hope) in these NoCAP markets is that sufFicient revenues will be earned from the energy markets (plus other ancillary services where applicable) alone to induce an adequate amount of new generation resources. The idea is that the inherent volatility of the energy markets will deliver enough high-priced hours dur- ingsummer- orwinter-peaking periods 24 Pueuc Ununes FoprNiexnr MAV 2005 www.fortnightly.com