The design and implications of demand charges in electricity capacity markets

While extensive research has examined how capacity markets address the missing-money problem in electricity markets, less attention has been devoted to how the costs of capacity markets are distributed to consumers. Here, we analyze the design options and implications of demand charges for refinancing electricity capacity markets, using both a conceptual framework and a numerical equilibrium model. We compare a flat demand charge with time-of-use and dynamic charges, which more accurately reflect the costs of building capacity to cover demand during periods of scarcity. We show that more cost-reflective demand charges induce e!cient substitution of demand response for capacity procured in the capacity market compared to a flat charge. Furthermore, demand increases when capacity is abundant, as no distortive charges are applied. As a result, more cost-reflective charges increase consumer surplus and drive the investment mix towards renewable energy sources. We discuss the implications of our results for the practical implementation of capacity market charges.