Government policy has created the need for capacity markets

The key issue with capacity is that it refers to a forward market, ie the incremental capacity that will be required in a future time period to meet forecast peak demand. And there lies the problem. Generators are understandably reluctant to invest in new future capacity unless they can guarantee a financial return on this capacity, particularly if the investment is to be based on debt.

Adding a further uncertainty into this future market scenario accompanies the global transition to a low carbon economy, with increasing investment in renewable generation technologies where most of this investment is being ploughed into intermittent generation plant, and primarily wind power. The clear concern here is that increasing investment in intermittent capacity potentially increases the future baseload capacity risks.

In Europe the need for a capacity market is transparently evident. With global coal prices falling in recent years Europe's coal-fired plant has displaced the more expensive gas- fired capacity, yet with Europe committed to reducing emissions it is imperative that cleaner gas-fired plant replaces unabated coal plant. But the economic reality is that increasingly gas-fired capacity is being mothballed and investment in new gas capacity is being deferred.

While the European Commission supports the concept of a capacity market Brussels is concerned that individual member state capacity markets could undermine the development of a single EU energy market. And its current concern is directed at the UK, with the recently legislated Energy Bill providing for the development of a capacity market mechanism with only UK generation eligible to participate.

Brussels' concern towards individual member state capacity markets is unfounded. Europe's energy markets differ on generation resources and costs and therefore require capacity markets that are tailored to their individual needs. To suggest that individual capacity markets will undermine a single EU energy market is tantamount to federalist scaremongering. Indeed Brussels should be actively promoting member state supply security at the lowest cost, and it is the member state governments that best understand how this can be achieved, not unelected Eurocrats. There is no 'one size fits all' solution to Europe's energy challenges.

While the European issue is unlikely to go away, particularly if the next EU energy commissioner appointed after the European elections in May supports the current Brussels position on capacity markets, it is worth considering how a capacity market is delivered, and the risks entailed. While capacity markets are sold on the supply security rewards provided, these rewards are not risk-free and there are also potential consequences with respect to affordability.

A capacity market's success is dependent on the ability to forecast future capacity requirements, and herein lies the major risk presented by these markets. If the primary purpose is to incentivise investment in new generation capacity then the date of the capacity forecast has to allow sufficient time for this new capacity to be built. In the UK market this means that capacity auctions will take place four and a half years ahead of the relevant delivery year. But how accurate will a forecast made this year be for capacity demand in 2018?

While it is accepted that a long lead-time is required to enable new plant construction, this does not apply to demand side response. Indeed few if any DSR suppliers would be able to commit to lower usage four years ahead of actual delivery, yet without active DSR participation the economic value of a capacity market is diminished as the potential for energy efficiency will be undermined.

Again taking the UK market as an example, the DSR issue will be mitigated by supplementing the advance four and a half year auction with a year-ahead auction. In essence this will be a balancing auction enabling the government to fine-tune the forward capacity requirements in order to reflect any changes to anticipated capacity demand following the original auction. As well as DSR this auction will benefit existing plant bidding into the capacity market.

The balancing auction raises another issue with capacity markets; are these markets primarily aimed at new capacity build or existing plant? Clearly existing plant will bid in to the capacity auctions at a lower cost than new plant build, yet it is also the reluctance of existing plant to return to operational mode (due to prevailing generation economics) that will partly influence future capacity requirements. It is therefore conceivable that plant could be mothballed today in order to inflate future capacity requirements that will make their future operational return more financially attractive.

There is ... a risk that a capacity market could be subject to gaming

There is therefore a risk that a capacity market could be subject to gaming. Indeed the provision of a secondary market in the UK, which is aimed at allowing plant that was unsuccessful in the original auction to bid for successful auction capacity that will not meet the operational deadlines, could unintentionally fuel such gaming. Indeed the secondary market provides an ideal opportunity for existing plant not to bid into an auction but to wait and see if any successful bids by new plant build fail to meet their supply obligations and then take on these capacity obligations and reap the financial rewards.

This may sound cynical, but this position has arguably been forced on generators by government policy. Because it has provided generous renewable support subsidies, penalised fossil fuel generation with carbon costs and failed to develop a more competitive gas market that remains largely price-indexed to oil, it is understandable that generators feel financially vulnerable towards new non-renewable base load capacity.

Simply put, government policy that is increasingly dictated by climate concerns has created the need for capacity markets. But whether governments can create capacity markets where the rewards comfortably outweigh the risks remains to be proven.

*Jeremy Wilcox is managing director of the Energy Partnership, an independent Thailand-based energy and environment consulting firm. Tel: +66 2 163 4073, Mobile: +66 8 6099 3375

(Originally published in MPS March 2014)