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How a Capacity Market Works

Adam James's picture
Center for American Progress
  • Member since 2018
  • 38 items added with 34,387 views
  • Jun 14, 2013


By Adam James

I have a confession to make. I am one of those folks who consistently write on wonky energy things without ever taking the time to write out simple explanations of the basic concepts or why they matter.

So, this piece will give a brief description of what electricity capacity markets are and how they work.

Part One: What is a Capacity Market?

There is a difference between energy and capacity, and power plants are compensated for both because both are important to maintaining the electrical system in different ways.  

Here is the distinction. A power plant generates electricity that you use in your home—and it needs to be paid for that electricity. This happens in the energy market. In these markets electricity is like any other commodity, bought wholesale and resold to consumers at retail prices.

However, some grid operators are experimenting with capacity markets, or “forward markets,” which direct investment a few years ahead of when electricity needs to be delivered. This is important, since power plants are expensive and take a long time to build; adding the additional risk that they may not even be used can obviously discourage investment.  Hopefully, these markets create long-term price signals for all resources.

The basic idea is that power plants receive compensation for capacity, or the power that they will provide at some point in the future. The way these markets are run in the PJM territory, there is an auction every year that has a delivery date three years away. This auction is called the Base Residual Auction. Then, there are smaller balancing auctions every year leading up to the delivery date where bidders can buy or sell their commitments. These are called “Incremental Auctions,” and occur just in case a power plant cannot meet its commitment, and needs to purchase replacement capacity from another power plant.

One quick note here: in these auctions, there is no functional difference between a megawatt of power from a power plant and a megawatt of reduced power from efficiency or demand response. So although I’ve been saying “power plants” to help picture this process, demand-side resources can also bid into the auction.


Part Two: How Do Capacity Markets Work?

Every resource bids into the auction at its total cost of operation. Since power plants depreciate over time, this bid can sometimes be very low if a plant has been around for a long time. This makes sense, since the capital investments in the plant have been paid off and the total cost of operations is mostly employees and fuel. New plants total cost of operation is higher at first, since it would include the capital costs plus the operational costs.

This means that what price a power plant bids into the market can vary quite dramatically. A 30 year old nuclear plant could actually bid in very low and a wind turbine that has zero fuel costs could have a much higher bid.

So what happens is that the grid operator holds an auction based on projections for what electricity demand will be in three years. When I say “electricity demand,” I actually mean peak demand for that entire year, plus a bit extra as a buffer (called a capacity margin).

Let’s look at a practical example, accompanied by a picture.

Pretend that the grid operator had to meet 550 megawatts of demand. This is absurdly low of course, it’s closer to 170,000 in PJM, but the process is much easier to imagine with smaller numbers. The grid operator will hold then hold an auction to try to get the 550 megawatts of demand met at the lowest cost to consumers.

So then every resource bids into the auction in at its total cost of operation. In our hypothetical auction below, I’ve arranged the stack from lowest to highest cost bids, and drawn a line at the point where enough capacity has been acquired to meet demand.

As you can see here, the cheapest resource is one wind turbine bidding in 50 MW of capacity at $30 per MW. But wait! Just because they bid in $30 per MW, that does not mean that the turbine receives 30 per MW. All it means is that the wind turbine is now committed to have 50 MW of power available in 3 years from now. Looking further up the stack, another turbine bids in 50 MW at $50 per MW. Even higher up the stack, you can see efficiency bid into the auction at $130 per MW, and a coal plant bid in at  $150 per MW.

So what compensation do they receive? In this example, all of the resources, including the wind turbine at the bottom, receive $150 per MW. This is called the “clearing price,” and it is set by the most expensive unit needed to meet demand. In this case, that is the coal plant (shown in orange).

This is important to understanding the dynamics between different resources in the market.

In this example, efficiency actually displaced a coal plant (shown in purple) whose total cost of operation was $160 per MW. Think about it this way; if efficiency had not bid into the market, then demand would have been 100 MW higher and that coal plant would have to be called on to meet demand. Then the clearing price would have been $160 per MW.

For what it’s worth, because there is the Base Residual Auction followed by a few Incremental Auctions, there can actually be some weird exchanges. In our example, imagine that the coal plant receives the $150 capacity payment but then goes offline due to equipment malfunction. Suddenly, they are on the hook for 150 MW of capacity that they cannot provide. So, in the next Incremental Auction they sell their 150 MW commitment.

If the clearing price in the Incremental Auction comes in at $130 per MW, the coal plant has (oddly enough) made $20 per MW. This is because they got $150 for something that someone else is now going to do for them for only $130.

The other story here is that in capacity markets, lower cost resources can have the effect of suppressing prices for all of the resources since they ensure that demand can be met at a lower cost. For utilities who own lots of expensive generation, this is bad for business. For a company who owns lower cost resources, it is good. Consumers always benefit from lower prices.

Capacity markets are important. They are the firing line for the electricity system of the future, because they direct and encourage investments in different kinds of assets—whether that is clean energy, fossil fuels, or demand side resources like efficiency. A book could be written on the criticisms of capacity markets, details on how these markets function, and how they can be harnessed more effectively, but this should give a good overview of the nuts and bolts.



Adam James is a Research Assistant for Energy Policy at the Center for American Progress, Executive Director of the Clean Energy Leadership Institute, and a Freelance writer for Greentechmedia. You can email him at and sure oughta follow him on Twitter @adam_s_james.




Nathan Wilson's picture
Nathan Wilson on Jun 14, 2013

So it sounds like when wind generators participate in capacity auctions (given that they can’t garantee their output on a given hour of a given day, years in advance) they are just speculating, and would ultimately end up buying or selling or a big part of their commits, in the hourly market?

My local utility owns a couple of wind farms, and buys the entire output of other farms through power purchase agreements (contracted for around 20 years before the farm were built).  This seems like a more sensable way to buy variable energy sources.

The capacity auctions are a reasonable way to deal the varying costs of fossil fuels, but they don’t seem very applicable to sustainable energy.

John NIchols's picture
John NIchols on Jun 14, 2013

Paying people to not consume energy is a Ponzi scheme. It will collapse when there is insufficient money to support the payments.  The fact that this nonsense is supported by the Center for American Progress is no surprise.  It is a lot like paying people not to eat, saying it is less expensive than buying food.  This is “true”; unfortunately, the “dieter” will starve to death in about two weeks.  In the same way, selling energy efficiency as capacity deprives the nation of real generation and “starves” the economy of the necessary capital to sustain and create real jobs.  A nation can not conserve its way to prosperity. Using less energy is the path that leads to poverty and misery.  



Adam James's picture
Adam James on Jun 15, 2013

Actually renewables just get a percentage of their bid accepted (I’ll check on the exact formula). Something like if 100 MW bids in then 30 clears. I believe it has to do with on-peak capacity projections.

Adam James's picture
Adam James on Jun 15, 2013

Well that is certainly an interesting view. 

The point of having efficiency bid into the market isn’t that demand reductions can provide electricity (obviously). It’s that if you have more efficient HVAC, you get the same results in your building while using less energy. That means a power plant doesn’t need to provide that energy.

As far as I know, the Center for American Progress doesn’t have any particular opinion on capacity markets. They are just a widely used tool across the country that ensure reliability on the grid. Calling efficiency bids in capacity markets a Ponzi scheme means I must not have explained them very well, or you don’t understand what a Ponzi scheme is. 

Real capital also goes into efficiency, and creates more jobs than equivalent investments in fossil fuels. After all, most efficiency upgrades are made in the Unites States. So not only are jobs created for installation, but also in the manufacturing of the products.

Kim Feil's picture
Kim Feil on Jun 17, 2013

Has the author of this article seen this report?  “….the owners of existing power plants will receive over $54billion, the largest share of capacity payments,”  


This statement makes me think that forward makets don’t help put existing ones of out biz-mayslow down new ones? but more importantly might not encourage renewables build outs?…..please let me know if capacity markets benefit renewables or just keep the status quo alive on big oil and gas.


Kim Feil's picture
Kim Feil on Jun 17, 2013

In Texas there is so much advertisment on free energy all night all weekends and this has me worried they don’t encourage energy consumption…but is this also a ploy to use less during peak hours so the grids don’t crash here in Texas?

Adam James's picture
Adam James on Jun 17, 2013

That’s a great question.

The short answer is that capacity markets do not have an inherent resource preference. They acquire the lowest cost resources needed to meet demand. If renewables are the lowest cost, then those would “clear” the market over moe expensive fossil fuels. If a coal plant is cheaper, it would clear instead.

What has played out, though, is that efficiency is often the lowest cost resource and so it will have a price suppression effect- since it clears in the market and brings down the total clearing price. The same thing happens with wind power in electricity (not neccesarily capacity) markets.

Renewables have zero fuel costs and higher capital costs, whereas fossil fuels tend to be the opposite. Basically, this means that older fossil fuel plants will likely be more competitive than new renewables, but that as renewables mature they get more competitive.

So in sum, it’s a little complicated. Capacity markets certainly make payouts to fossil fuels, since they are required to meet reliability. However, renewables are also receiving payments in the market and it gives another revenue stream to their projects (which is a good thing).

There are some structural problems with capacity markets- and I think capacity markets *could* be used to direct investment much more into renewables, but that’s probably enough for a whole ‘nother post.

Adam (@adam_s_james)

Elias Hinckley's picture
Elias Hinckley on Jul 11, 2013

Americans are obese (relative to the rest of industrialized society) incentivizing them to eat less will make them healthier. Promoting a reduced diet is healthy (that’s diiferent from eating nothing). 

Our energy use has been (though slowly improving) much like our diets, unnecessarily overconsuming. Not to suggest capacity markets are perfect (far from it), but responsible consumption is healthy and promotes efficiency – economic efficiency. 

Adam James's picture
Thank Adam for the Post!
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