Carnegie Mellon Electricity Industry Center

2003-04 Seminars

An Examination of Capacity Markets in Electricity

Alex Galatic and Frank Lacey
Strategic Energy

Abstract

Demand for electricity constantly fluctuates and depends a great degree on one unpredictable factor - the weather. Tomorrow's weather might be relatively certain, but next summer's weather is less so. At the same time, supply is vulnerable to equipment failure that may, at least temporarily, remove a significant source of electricity from the market. As millions of people experienced the blackout on August 14th, 2003, electricity is an important, if not essential, commodity.

Uncertain demand coupled with uncertain production capability for a valuable commodity indicates a need for storage, but electricity is consumed at the same instant that it is generated, and it cannot be stored in significant quantities. In other words, electricity supply cannot be inventoried - at least not directly. Generating facilities fill the role of inventory, so, although electricity in its final form is not stored, in a way, it is stored as fuel in coal piles, natural-gas storage fields, and oil tanks, standing ready to be converted into electric energy.

We depend on the idle production capacity of generators to provide the inventory necessary to compensate for the loss of a large production facility or an abnormal increase in demand due to extreme weather - and keep the lights on.

Some regions in the Northeast have attempted to create "capacity markets" intended to encourage the development of supply reserves adequate to protect reliability, but they have been ineffective at best, and perhaps even create disincentives to build reserve capacity. This discussion examines why capacity markets in the Northeast fail to encourage the development of new generating capacity, and even worse, how they harm competition.