France as a capacity market example
A capacity market has been in place in France since 1 January 2017. There, trading is conducted with certificates for capacity guarantees. These guarantees ensure that power producers will reserve capacity to generate power at a certain time – it does not mean that the producer will actually produce power at that time. It is simply an assurance that the producer has the ability to generate power during the stated period. France's capacity market was not introduced based on market principles, but due to power shortfalls from the lack of flexibility in the country's power production, which is supplied primarily by nuclear and fossil fuel plants. Most French homes are heated electrically, meaning a temperature drop of one degree Celsius in the winter causes a 2,400 MW increase in demand. Sudden, long-lasting cold snaps led to serious supply problems in 2012, 2017, and 2018 – introducing centralized capacity control measures during the winter months was the result.
Supply guarantees on the energy-only market
Up until a few years ago, experts did not believe the energy-only market was capable of guaranteeing supply. The main criticism was that market activity alone would not provide the money needed to expand reserve capacity. In practice, however, the energy-only market shows that supply can be guaranteed in a free market model, such as the one that exists in Germany.
Part of guaranteeing supply in an EOM is the control reserve market, which serves as a very short-notice capacity market for balancing network frequency. When needed, Transmission System Operators can switch capacity reserves on or off in seconds, a quick and reliable way to stabilize the network for up to an hour. Depending on the market model, it is the capacity provision and/or the delivered capacity that is compensated.
To guarantee supply in the long term, additional reserves are part of most energy-only markets. In Germany, these are the network, security, and capacity reserves. These reserves – operated partly for political reasons and partly for strategic reasons – are conceptionally similar to capacity markets. In Germany, they compensate capacity from power plants that are temporarily offline, are utilized as cold reserves, or are simply in standby mode.
What are the economic benefits of an energy-only market?
The energy-only market brings the economic principle of supply and demand to the power market. This makes the market more efficient, reduces overcapacity, and encourages flexibility in power production – when demand changes, power production adjusts to match power consumption.
This principle can be explained using a simple example: No baker is paid to simply have to the capacity to bake bread. Instead, a baker earns a certain price for each loaf of bread, and the price fluctuates according to supply and demand. To avoid sitting on a large supply of stale bread, the baker adjusts the number of loaves to meet the expected number of customers. There is always the option, looking ahead, to bake more bread if needed.
On the capacity market, there is essentially a steady demand for bread – but the baker still must maintain several additional ovens that aren't needed on a day to day basis. This leads to high maintenance costs and overcapacity. This occasionally occurs also on energy-only markets, because true free-market operation without market-distorting subsidies only happens in theory, but never in practice.
In addition, even if large power plants have become more flexible with quicker reaction times, it is still difficult for them to respond to fluctuations in the power market's demand with capacity adjustments. Nuclear power plants are effectively incapable of these adjustments. If domestic demand is low and/or there is a lot of power from renewable energies on the market, the result is that plants that are taken offline, an increase in power exports, and negative prices on the power exchanges. These circumstances mean that preferred, environmentally-friendly installations (such as gas plants) are no longer viable.
Disadvantages of energy-only markets: The missing money problem
Critics of the energy-only market view the sufficient provision of secured capacity as problematic: It is difficult to find investors for peak-load installations that only run for a few hours a year; these few hours are also the only times when peak-load prices are realized. In addition, constructing a power plant can take ten years or more from the initial planning phase to implementation – a period that sees no returns and is subject to dramatic changes on the market.
High energy prices are also politically inconvenient. If prices on the energy market could develop entirely on their own, the per-MWh price on the exchange would be theoretically infinite. In practice, the EPEX limit on the intraday market is 9,999 euros per MWh over short periods. These high prices, even if they were only assessed for a few fifteen-minute periods per year, would hardly stand a chance against politicians and the press. National authorities also intervene at a regulatory level in pricing: The German Bundesnetzagentur (Federal Grid Authority) set a price limit for control reserve energy of 9,999 euro per MW on 5 January 2018.
Decentralization as a solution to the missing money problem
The arguments behind the missing money problem are understandable, but they are taken in the context of the old energy market. To guarantee peak-load capacity, this market relies on large power plants that take a long time to build and require correspondingly large and long-term investments.
Investments in a decentralized infrastructure that supplies secured capacity from several smaller assets is much easier and quicker to set up. A CHP or power storage asset can be planned and built in just a few weeks, meaning secured capacity and control reserve is available quickly. This would mean that capacity shortfalls from conventional power plants scheduled to be decommissioned could be compensated in a reasonable timeframe with acceptable financial impact without affecting the guarantee of supply.
Free pricing and supply guarantee on the energy-only market
On the capacity market, creating supply guarantee is simple: build more power plants. The market design guarantees that the resulting additional capacity will be accepted. In contrast to the energy-only market, it is not the supply that primarily influences the market, but the demand. This is especially attractive for large plant operators, because even plants that are waiting on standby or only used when demand spikes are compensated. Compared to peak-load prices that are allowed to develop freely, fossil-fuel power plants are given unevenly high prices for power that isn’t even needed on the market. The medium and long-term environmental, economic, and climate costs of these plants, with fossil plants as a prime example, are not reflected.
Switching to the broader European perspective, taking a strictly nationalistic view of the supply guarantee problem leaves the true potential of the pan-European energy market untapped. Sources of renewable energy are spread unevenly across various European countries and could balance each other out. Norwegian hydro power, solar power from Spain and Italy, tidal plants in the Netherlands, and biogas or wind power from Germany would help stabilize the European power grid.
However, this would require seriously expanding the integrated European grid to reduce trade barriers, such as efforts to increase the capacity of cross-border interconnectors. The fact that these are not currently adequate was made clear in a 2017 decision to separate the common German-Austrian power price zone on 1 October 2018. The close-knit network that handles the physical flow of power in Europe therefore leads to a paradoxical problem: With an increasing amount of power that does not cross national borders, the European energy market will continue to be divided against itself as long as an integrated European power market concept is lacking.
Market efficiency and merit order
On the energy-only market, establishing supply guarantee is more complex, but also more efficient. Supply and demand dictates the prices on the power exchange and, therefore, the utilization of power producers and (increasingly) consumers.
If supply shortfalls on the market are higher than usual, the price of power goes up on the exchanges. Eventually, power plants – depending on their marginal prices according to the merit order principle – will be activated to balance out the supply shortfalls. As a last resort, peak-load assets such as gas, oil, or pumped-storage plants come online to sell their urgently-needed megawatt-hours at very high prices.