Capacity Mechanisms in the Electricity Sector
Salome Janelidze, member of the Energy Training Center at GNERC spokes about Capacity Mechanisms in the Electricity Sector:
“The fundamental principle of electricity system operation is the constant matching of demand and supply. Unlike other products, electricity storage is associated with complexity and high costs. Accordingly, electricity should be consumed at the time of its generation. A breach of this balance can have severe consequences, such as a power system blackout and damage to infrastructure and electrical equipment, which in turn has complex economic and social impacts.
Maintaining a balance in the electricity system and a stable supply of electricity is the function of the system operators. However, the increasing share of renewable energy in the energy mix presents them with new challenges. One such challenge is generation variability: solar panels generate electricity when the sun shines, and wind turbines generate electricity when the wind blows. The unpredictability of solar and wind energy production leads to periods of production shortages when demand for electricity exceeds supply, as well as periods of overproduction, which overload the power system. In addition, the challenge for electricity system operators is compounded by the fact that the peak production period of solar energy usually does not coincide with the peak demand for electricity.
According to economic theory, the price of electricity is the most effective mechanism for balancing supply and demand. In liberalized markets, electricity prices are determined based on real-time supply and demand. During peak demand for electricity and insufficient supply, electricity prices increase sharply, which is called peak pricing. A high price, in turn, sends a signal to consumers to reduce their electricity consumption, thus helping to balance the system without the intervention of regulators. At the same time, the peak price is an essential indicator for investors. The price of electricity in day-ahead markets usually does not allow the recovery of fixed costs for power plants with relatively high marginal costs, and the periods of peak pricing are essential for recouping these costs. An example of peak pricing is the 2021 crisis in Texas when the price of one megawatt-hour of electricity was $9,000 for four days.
Despite the effectiveness of peak pricing, it also has disadvantages. A sharp increase in electricity prices, even for a short period, can have severe political and economic consequences. To ensure system reliability and avoid system-wide blackouts, capacity mechanisms are a more acceptable alternative to peak pricing for many countries. Unlike energy markets, where electricity producers are compensated for the electricity they generate, in capacity markets, producers are also compensated for the availability of capacity that can be used to generate electricity if needed. As a result, the system operator always has access to the firm capacity to meet the peak load.
The most common types of capacity mechanisms are capacity markets and strategic reserves. A capacity market involves a central auction by the system operator to purchase a predetermined amount of capacity. Electricity producers place bids at the auction, and the winners receive a fixed income for the capacity offered. As for strategic reserves, agreements are signed between the system operator and electricity producers for a predetermined capacity. Strategic reserves are activated if there is a production shortage or the energy price on the organized markets exceeds a certain threshold.
The possibility of implementing capacity mechanisms is foreseen by the EU acquis, which allows Member States to determine the need for capacity mechanisms based on adequacy assessment, which is carried out at the European and national levels. However, since the capacity mechanism represents an artificial intervention in the functioning of markets, it is considered to hinder competition and the entry of new players into the market. Therefore, the Clean Energy Package adopted in the EU in 2019 mandated that the capacity mechanisms in the EU are a temporary measure to ensure an adequate level of resources, and their use is allowed as a last resort if the implementation of market measures is insufficient to solve the adequacy issues. Before introducing the capacity mechanism, specific measures must be implemented. In particular, Member States should assess existing regulations that distort the market and contribute to the risk of insufficient capacity availability. In addition, considering the energy transition goals, the EU regulatory framework provides for a threshold of CO2 emissions for electricity producers participating in the capacity mechanism.
The EU approach was revised as a result of the electricity market reform implemented following the energy crisis of 2022. Capacity mechanisms became a structural element of the electricity market instead of a measure of last resort. However, the new regulation places increased emphasis on using flexibility measures such as demand response and electricity storage instead of fossil fuel-operated power plants.
Demand response involves reducing or increasing electricity consumption by customers in line with the systems’ needs and in exchange for certain financial benefits. A demand response mechanism better reflects consumer needs than a capacity mechanism and promotes market efficiency. The use of aggregated resources such as electric vehicles, heating and cooling systems, and household appliances, which can be turned on and off remotely according to system needs, is particularly effective for demand management. However, to utilize the demand response potential, it is necessary to provide appropriate technical solutions, such as smart appliances and meters, and the proper design of financial incentives so that consumers do not inflate their consumption to receive compensation in exchange for a reduction.
A recent change in the EU's approach to capacity mechanisms reflects the importance of system stability and efficiency in the modern energy landscape. Implementing sustainable measures such as market mechanisms and flexibility services is necessary to operate a reliable, sustainable, and cost-effective electricity system while working towards the goal of energy transition”.