Resource adequacy is the current hot topic in electricity policy. Fueled by the glacially incremental restructuring process in the states and concerns about service reliability in this persistent policy limbo, states and regional system operators have explored a variety of means of providing forward-looking reliability incentives in the absence of the regulatory mandate to vertically-integrated utilities. One incremental approach is capacity markets. In a capacity market, system operators solicit offers from generators to provide a guarantee of future capacity to provide power, based on the system operator’s need to meet a specified, engineering-determined reserve margin over and above forecast demand. In capacity markets that have been implemented or proposed in the U.S., the forward timeframe can range from one day to four years.
The typical argument offered for the implementation of capacity markets invokes the lack of retail demand response, which makes active, double-sided forward markets impossible, and the lack of developed, liquid, integrated spot and forward energy markets. Notwithstanding the chicken-and-egg nature of this conundrum, implementing a capacity market in isolation, based on an artificial demand curve (regardless of its slope), does not do anything to reduce the barriers to active retail demand. Furthermore, technological advances and increasing numbers of retail demand projects show that empowering demand response is not as expensive or as distant a task as capacity market advocates claim.
Another cautionary note for capacity markets comes from their focus on providing the “missing incentives” for investment in generation capacity for the future. But there are four resources in the portfolio of resources that we can use to ensure future system reliability: generation, transmission, demand reduction, and technological innovation that can affect any or all three of the other resources. Creating incentives for generation leads to inefficient distortions in cases where one of the other resources might be better suited to a particular case, or might be less expensive, or might be more flexible and adaptable on the network.
California is currently considering implementing a capacity market, and has requested comments. In a recent paper, which the Alliance for Retail Energy Marketers submitted to the CPUC, I analyze these issues and present an alternative model for enabling system reliability through resource adequacy. Capacity markets do have benefits in terms of increasing price transparency and market liquidity, as well as providing a platform for load serving entities to buy and sell capacity. Rather than adopt a capacity market that is based on an artificial demand curve to complement the state�s existing resource adequacy requirements, however, the best resource adequacy policy that California could follow would be to eliminate the current regulatory barriers that impede demand-side participation in the wholesale and retail markets (i.e., participation by end-use customers and LSEs). A second priority should be to develop integrated spot and forward energy market platforms that transmit accurate price signals to investors and entrepreneurs. While achieving these two priorities will take time, a transitional approach that employs known, tested financial instruments, such as call options, could bridge that gap. By flexibly accommodating generation, transmission, and new demand-side resources and technologies, this recommended approach is more likely to generate long-run benefits for California customers than an artificial capacity market that would be both costly to implement and difficult to dismantle once it became obsolete.