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A Capacity Market that Makes Sense

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Abstract

We argue that a capacity market is needed in most restructured electricity markets, and present a design that avoids the many problems found in the early capacity markets. The proposed locational capacity market pays suppliers based on their demonstrated ability to supply energy or reserves in shortage hours—hours in which there is a shortage of operating reserves. Thus, only supply that contributes to reliability is rewarded. The capacity price responds to market conditions. When capacity is scarce the capacity price is high; when capacity is plentiful the capacity price is low or zero. Market power in the capacity market is addressed by setting the capacity price based on actual capacity, rather than bid capacity, so generators cannot increase the capacity price by withholding supply. Ex post peak energy rents (the short-run energy profits of a benchmark peaking unit) are subtracted from the capacity price. Thus, a supplier does not have an incentive to create real-time shortages—the high shortage price resulting from a shortage is subtracted from the capacity price, so there is no net gain from the high price. By defining a capacity product closely tied to reliability and directly addressing market power both in the capacity market and in the spot energy market, the proposed design results in a market participants can trust to encourage efficient behavior both in the short run and long run.

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File URL: http://www.cramton.umd.edu/papers2005-2009/cramton-stoft-a-capacity-market-that-makes-sense.pdf
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Bibliographic Info

Paper provided by University of Maryland, Department of Economics - Peter Cramton in its series Papers of Peter Cramton with number 05licap.

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Length: 13 pages
Date of creation: 2005
Date of revision: 2005
Publication status: Published in Electricity Journal, 18, 43-54, August/September 2005
Handle: RePEc:pcc:pccumd:05licap

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Postal: Economics Department, University of Maryland, College Park, MD 20742-7211
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Web page: http://www.cramton.umd.edu

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Keywords: Auctions; Electricity Auctions; Capacity Auctions; Market Design;

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  1. Hobbs, Benjamin F. & Iñón, Javier & Stoft, Steven E., 2001. "Installed Capacity Requirements and Price Caps: Oil on the Water, or Fuel on the Fire?," The Electricity Journal, Elsevier, vol. 14(6), pages 23-34, July.
  2. Peter Cramton, 2000. "Review of the Reserves and Operable Capability Markets: New England's Experience in the First Four Months," Papers of Peter Cramton 99reserves, University of Maryland, Department of Economics - Peter Cramton, revised 03 Jan 2000.
  3. Besser, Janet Gail & Farr, John G. & Tierney, Susan F., 2002. "The Political Economy of Long-Term Generation Adequacy: Why an ICAP Mechanism is Needed as Part of Standard Market Design," The Electricity Journal, Elsevier, vol. 15(7), pages 53-62.
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