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 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 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 charged. 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.