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Capacity payments may be the solution

3 March 2010

This year marks two decades since the privatisation of the UK energy market. It is an appropriate time to analyse, evaluate and question its fitness for purpose. Demand threatens to outstrip supply in the next few years, while the market and the regulator are under pressure not just to fill the looming energy gap and keep down prices, but to demonstrate that the current market formulation will support the investment required to drive decarbonisation.
There is fighting talk of radical reform, restructuring and step changes from politicians, and a growing sense that it is time for big ideas in the energy sector. One such idea is capacity payments. These are hardly a new concept. We used to have them in the pool system that operated from 1990 until 2001. Under the old system, generators set the wholesale price of electricity (the system marginal price) via a bid process. In contrast, Neta (now Betta) created a commodity-type market in which both generators and suppliers can trade electricity. The idea of such a competitive market system was to bring down prices for consumers. But as recent years have shown, even where prices have come down, it's a rare day when such savings actually reach customers.
Perhaps the greatest problem now is the need for investment. Energy companies rightly point out that the current system, combined with decades of excess supply and low fossil fuel prices, provided little or no incentive to build the new capacity required. The reality is that without stable market signals and a long-term regulatory framework in place, would-be investors do not see Britain as a commercially viable option for the enormous levels of expenditure involved. Capacity payments and the establishment of a forward capacity market, including renewables and demand response resources, would be a radical, yet logical, consideration.
In any functioning competitive market, price should reflect supply and demand of goods. Unfortunately in the energy market, we cannot always predict levels of future demand, and this will become increasingly problematic as intermittent supply plays a greater role in our energy mix.
Capacity is a form of insurance. It guarantees that when all consumers wishing to use energy are attempting to do so, the supply will be present. However, without additional economic benefit for providing such insurance, the industry has no incentive to do so.
Capacity payments and a forward capacity market are designed to ensure future peak demand will be met and to encourage investment in existing and new power sources. Paying generators for capacity they make available, as well as energy they actually supply, addresses these issues and improves the future stability of the grid.
A forward capacity market, in which generators are paid in advance at competitive prices for supplying future peak demand, would increase service reliability and allay fears of power outages, and would provide stable funding streams on which to finance generation investment.
To overcome the issue of uncertain levels of demand, in most models, the regulator or another body projects the future needs of the system and holds an auction for the right to fill them. Generators are encouraged to build more capacity, with risk levels lower because advance capital and early indications of excess demand are provided. An added benefit would be a market that functions to include not only traditional generation and renewables, but also reduced electricity use through demand-response sources. There are financial savings and environmental benefits to allowing energy efficiency to be traded on an equal footing with actual power supply, not least encouraging demand-side response products and creating the potential for consumers to participate in the market.
Of course, there are potential pitfalls, such as the risk of inaccurately forecasting demand levels. Even advocates of forward capacity markets caution against a straight return to a pre-Neta system. The serious logistical and economic implications of a full-scale reversal of 20 years of liberal energy markets make such a move unattractive politically and unlikely on a practical level.
However, in terms of providing long-term investment signals and creating a market that incentivises and delivers a reliable mix of supply solutions, a system that incorporates capacity payments and capacity markets may solve some of our more immediate and serious problems.
Jessica Lennard, senior consultant, Hanover
Source: Disconnector

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