Governments want to make sure the lights stay on during the most challenging moments of the year — think freezing cold days when the wind is not blowing and the sun hides behind grey clouds. Around Europe and further afield, governments have started looking for ways to pay power plants, battery parks or renewables to be available on call, in case they are needed to plug the gap.
RAP has long-standing concerns with many of the approaches adopted, a big one being “capacity markets,” which are so popular at the moment, that they may as well be a new initiative that Taylor Swift just announced. (For more info, visit our Power System Blueprint deep dive on capacity markets.)
Bram Claeys, a senior advisor on RAP’s EU power team, has a chat with his inner teenage self on the topic in a desperate attempt to get his concerns across.
Oh it’s you – well, did we win the Tour de France?
Uh, no. Nice to meet you too. I’m here to talk with you about how to avoid the worst pitfalls of capacity markets.
Or we could talk about just how and when you killed my dreams of winning the Tour de France…?
No. Capacity markets is the title of this piece, so I’m just going to plough in.
Best to get a move on then. S’pose you’re going to explain to me what a capacity market is?
Capacity markets come in different shapes, but typically a government minister or other official looks in a crystal ball, decides how high electricity use might peak in a given year, taking into account how much renewables and imports from other countries may help. Then the government runs an auction to determine how much extra money electricity market players need to promise to be available when needed. At the moment they’re mostly signing contracts with gas-fired power plants and the like. You know, the stuff we are trying to get rid of, to tackle climate disruption.
You mean you haven’t yet sorted out our carbon emissions? It’s only the biggest threat to humanity…
No, we haven’t yet. But we’re making some progress. Let’s stay focused though. Capacity markets at first blush sound fine — their goal is to ensure reliability, right — to keep the lights on. But they tend to come with lots of problems.
Name one then.
Well, the way contracts are struck often seems to leave wiggle room for the power plants to avoid actually showing up when required and without many consequences.
Name another one.
They may be prone to a systemic risk of procuring more resources than is actually efficient.
Governments tend to buy more than they need.
Well actually, an illustrative analysis by UK energy watchdog Ofgem showed that just buying 3% more than initially planned could double the gross costs borne by consumers of an auction. We’re talking easily hundreds of millions of euros — or pounds in their case.
Hmm. That could buy a lot of chocolate.
Or Trappist beer. Anyway, we have a few recommendations. Let energy nerds who are independent of politics do a deep check of the volumes to buy. Draw on calculations conducted at grander supra-national levels — called European Resource Adequacy Assessments. We’re all connected to each other, after all. But it’s a hard one to overcome and is another reason why we think entirely different approaches are preferable.
Not so fast. You said lots, but you’ve only named two drawbacks.
Well, others include that the cost to pay for this top-up tends to be spread across consumer bills over a year, instead of recouped at the time when those costs are made, like when we need to pay those plants. That’s a lost opportunity to use those costs to actually help with the problem. If the time when we are running out of resources to keep the energy system going is also when we recoup costs of capacity contracts, that additional cost may motivate businesses and people to avoid using electricity during those times. That so-called “demand response” makes the problem immediately a lot smaller. This matters in particular because one of the weak points of capacity markets is that they don’t manage well to get contracts for demand response.
OK, that’s three.
Another one: they typically offer long term contracts for new build that risk putting the consumer on the hook for carbon-emitting power plants for many years. So it’s in any case best to limit the contracts to one year, like they often do in the U.S.
Hmmm, and are you actually in favour of anything?
The best solution we think is getting the price right. A funky tool called reserve scarcity pricing gives confidence to the market that wholesale prices will go up nicely when it will be helpful to unlock the resources needed, which should make investors comfortable enough to build new stuff to help make sure the lights stay on. A “real time reserve market” is another clever innovation that allows the expectation of these spiky prices to inform prices in earlier markets like day ahead, where most of the value of market trades sits. That reduces the risk in making investments in response to these prices. These solutions address concerns directly, and leave the market to do what it does best: being all market-y and getting stuff done.
Why doesn’t everyone do this?
Much of this is quite innovative. Critics say that a capacity market makes it cheaper to invest. But it’s tricky to get it right. You need way fewer crystal balls to get reserve scarcity pricing right. It’s not so much that is gets us the lowest cost of financing investment — it won’t. But it is a lot more adaptable to unexpected developments in times where the future is arguably less predictable than ever.
Right, are we done?
No. Recap what you learned.
Um, everyone is jumping into capacity markets but they have lots of problems. There are some basic solutions —independent scrutiny, avoid long term contracts. But some problems are so hard to overcome that best is to address the problem properly with reserve scarcity pricing and real time reserves.
Thanks, big Bram!
Wow, good listening little Bram!