Management

Capacity Mechanism are described as policy instrument for ensuring an adequate level of electricity generation capacity [66]. A summary proposed in [16] defines a CM as follows:

A CM is a mechanism to value generation or demand response capacity, generally but not always leading to a revenue stream to owners of such capacity in addition to revenues from the energy market.

The main elements of the working principle that is uniform to all mechanism are as follows:

A CM values availability or firm capacity, as introduced in Section 1.1. The CM introduces an additional and complementary mechanism besides the energy market to influence the volume of installed generation capacity as well as the type of installed capacity [67]. The value is typically remunerated via a payment expressed in e/MW. Note that the origin of the capacity is not specified by the mechanism. Hence, while mostly CMs are perceived mechanisms for conventional generation, there is no limitation to the technology of capacity providers. Participation of demand response, storage applications, interconnection cables, RES are equally possible if they can provide the respective value of firm capacity. A CM is intended to provide a steady revenue stream. Instead of hourly or more frequent energy and reserve markets, the steady revenue stream of a CM originates from a periodic, often annual, determination of the level of remuneration. Consequently, the remuneration fluctuates less. Moreover, it only depends on the installed capacity, rather than more and more decisive elements on the short-term markets [46]. With respect to investment into new capacities, the flattened revenue stream adds to the incentives from price spikes

36 CAPACITY MECHANISMS IN MULTI-SERVICE MARKETS

and scarcity rents to a steadier and hence more reliable market signal [68]. Depending on the mechanism, a CM might also completely replace incentives from price spikes and scarcity rents.

The purpose and desired outcome of a CM is to resolve potential distortions emerging from market malfunctioning. In order to correct these distortions, CMs form a complementary mechanism to the current markets in place rather than being designed to replace them [69]. Via the mechanism, the objective is to positively influence investments leading to long-term generation adequacy [28]. Finon and Pignon [70] state that market design that includes a CM should create conditions to guarantee sufficient capacities to supply the aggregated electrical demand and energy requirements. A CM is often characterized as a mechanism that “guarantees” generation adequacy. However, a guarantee cannot be provided by a market design that depends on individual decision- making. A CM is rather a mechanism that reduces the risk of having insufficient capacity by providing an adequate market signal.

Other positive effects of CMs hint at the market distortions as described in the previous section. According to [41], a CM reduces the possibility to abuse market power due to scarcity. At the same time, it protects investment in capacity against the missing money problem caused by the consumers’ limitations to directly express their value of reliability and regulatory interventions like price caps [68]. The reason is that CMs transform implicit social preferences for security of supply into explicit target capacity demand [49] and consequently into an added remuneration for capacity contributing to the security of supply. From a regulators and consumers’ perspective, a CM can also be interpreted as an insurance against ENS. In terms of social optimum there is a trade-off between the social cost of electricity shortages and the cost of excess capacity [71] (Figure 2.9).

If the social optimum is assumed to be reached if installed capacity is equal to the peak demand leading to lowest cost, both excess capacity and capacity shortage result in additional cost. The cost of excess capacity can be approximated with the additional cost for new peak power plants, i.e., the Cost Of New Entry (CONE). The additional cost for capacity shortage is linked to the ENS and the associated VOLL. Typically, the VOLL is assumed to be high enough, that even after deducting the deferred investment for peak capacity the additional cost is positive. Even more, the increase of additional cost is assumed to be steeper on the side of capacity shortage as opposed to excess capacity.

Typically, from a social point of view a CM seems beneficial as it decreases the risk of ending up with capacity shortage. In other words, given uncertainty, the socially optimal volume of generation capacity is higher than the theoretical

TERMINOLOGY OF CAPACITY MECHANISMS 37 CONE− ENS·VOLL ENS·VOLL −CONE Peak Demand Social Optimum Excess Capacity Capacity Shortage Installed Capacity [MW] → A dditional Cost[ e ] ENS·VOLL

Cost of New Entry (CONE)

Figure 2.9: Social cost of electricity shortages and excess capacity optimum in the presence of perfect knowledge [72]. The potential additional cost of excess capacity is considered a reasonable price for the insurance not to end up with a shortage. Even more, for policy makers, the VOLL is often higher than the consumers’ perspectives. In the context of very risk-averse national policy makers that want to prevent lights from going out in the country, one could also speak of a value of lost vote. Like the VOLL, it is very hard to determine, however, often it is incentive enough to promote a CM at a national level.