The purpose of the capacity market is to provide an additional revenue source to power plants, as an added incentive for plants to stay online. If it were not for the installed capacity margin requirement, price inelastic demand and wholesale price caps, capacity markets would probably not be needed. Even so, some have argued that capacity markets are not needed anyway. The Kleit and Michaels reading on Canvas, "If You Pay for the Power, Why Ppay for the Power Plant?" outlines one argument against using capacity payments to provide more revenue for generators.
In this section, we'll discuss how the capacity market actually works. We'll use PJM's capacity market (known as the "Reliability Pricing Model") as an example, but most capacity markets work in a similar way.
The capacity market is run as a uniform price auction for a forward capacity contract. Since it operates as a uniform price auction, the market clears the same way that the energy markets clear - suppliers submit capacity offers, the RTO orders those from smallest to largest, and it then uses a demand curve for new capacity to determine the market clearing point.
Suppliers that clear the capacity market have an obligation to have their cleared amount of capacity on-line and ready to generate power at some point in the future. In PJM this capacity obligation is for three years in the future. In some other RTOs, the capacity obligation is for one year in the future. In exchange, all capacity that clears the capacity market receives the clearing capacity price. Both existing power plants and planned new power plants are eligible for these payments.
The capacity market operates in three steps.
First, the RTO determines the installed capacity requirement, which is the amount of capacity needed to meet demand plus the capacity reserve margin.
Next, the RTO calculates a price cap for the capacity market, which is known as the Cost of New Entry or CONE. The CONE is basically the capacity cost of a new gas-fired power plant. It also calculates a figure called "Net CONE," which is the CONE minus an estimate of the energy market revenues for the power plant. The Net CONE is thus an estimate of the missing money for a power plant.
Finally, the RTO determines a demand curve for capacity. The method for determining the demand curve does not have any specific economic logic other than being downward sloping, so don't read too much into the shape of the demand curve. An illustrative capacity demand curve is shown in the figure below. Note that the horizontal axis uses units of the percentage above or below the installed capacity requirement while the vertical axis uses units of proportion of Net CONE.
The shape of the demand curve is determined by the following parameters:
- The capacity clearing price is equal to the CONE for capacity quantities up to some percentage below the target installed capacity requirement. In the figure above, this is point a, which is set at 3% below the capacity target.
- From point a, the demand curve slopes linearly downward until some percentage above the target installed capacity requirement, at which point the price becomes equal to the Net CONE. In the figure above, this is point b, which is set at 1% above the capacity target.
- From point b, the demand curve slopes downward more steeply until it hits a larger percentage above the target installed capacity requirement. In the figure above, this is point c, which is set at 5% above the capacity target and sets the price at 20% of Net CONE.
- Beyond point c, the capacity clearing price is zero.