Revisiting capacity market fundamentals

Many liberalized electricity markets use capacity mechanisms to ensure that sufficient resources will be available in advance of operations. Recent events have called into question the ability of capacity mechanisms to provide sufficient incentives for reliability. A core challenge is that penalties for non-performance on capacity obligations are lower than what theory would suggest is economically efficient, giving suppliers an incentive to overstate their contributions to reliability. System operators mitigate the effect of weak incentives by conducting accreditation studies that limit the size of the capacity obligation taken on by suppliers. However, the technical and administrative complexity of these accreditation studies has contributed to ongoing challenges for reliability and efficiency. This paper reviews fundamental elements of capacity accreditation, developing a theoretical framework that ties optimal accreditation values to economically efficient price formation. We then describe current inefficiencies and identify several assumptions stressed by the transition to variable and fuel-constrained resources. In light of these challenges, we argue that the clearest path of reform is to reduce reliance on accreditation studies, instead working to restore economic incentives through larger non-performance penalties. Given the financial risk this implies for suppliers, accreditation studies would nevertheless remain important in order to assess credit risk and prevent the use of bankruptcy as a hedge.