Research September 19

Capacity Markets: Do we need them?

Possible replacements for Capacity Markets

Before the 1990’s, the country was in the midst of a power crises. At such a juncture, IPPs came to the rescue of the Pakistani economy. However, from that solution, a seemingly innocuous clause of capacity payments has evolved into a major national issue. In the aftermath of such contention, the power exchange market is being touted as a panacea to the problems of capacity payments. However, before boarding the power-exchange train, designers of the industry need to analyze the phenomenon of Capacity Markets (CM) and analyze its feasibility for the power sector.

Why capacity Markets are proposed

Capacity markets are proposed as a remedy for a number of problems in the market. The most often cited reason for introducing capacity markets is the theory of “Missing Money Problem”. Other reasons include economic theory of oligopoly and deadweight loss to consumers.

Missing Money Problem

Power exchanges all over the world are experiencing the “missing-money” problem. The “missing-money” problem originates because, like all markets, power exchanges were entrusted with the responsibility of deciding prices in the short term and investment in the long-run. Everyone agrees on the ability of power exchanges to provide the best prices in the short-run. However, there are doubts about the market’s ability to provide enough incentive to invest in incoming plants.

Many market players believe that the tariffs may be too low for investors to replace retiring capacity and add new capacity required for increased consumer demand and providing reliability services for Renewable Energy. These pessimists believe that the power sector will see a sudden rise in demand, which will not be satisfied by the under-invested power sector. Therefore, the money required to promote investments is “missing”.

This money is then indirectly provided by the government via various methods. The two most common methods are putting Capital Adequacy Ratio requirement on grid operators and instituting Forward Capital Markets for future capacity. Capital Adequacy Ratio creates contractual obligations on retailers to pay for Forward Capital markets. Both the solutions involve paying power producers merely for possessing capacity. This payment for capacity is justified on the basis of basic economic theory where the production cost (power exchange price) is lower than the societal cost (lack of reliability of power supply). In the absence of CM, the market is expected to go into a boom-bust cycle. CM are expected bring production cost at par with the societal cost. However, critics of CM fundamentally use the argument that paying firms for capacity stops market from determining investment in the sector.

The supporters of the missing money problem make some implicit assumptions in their justification of CM. The first assumption is that consumers cannot adjust their consumption in response to the changing supply portfolio of power. The second assumption is that base-load power generation is cheap while peak load power generation is more expensive. The third assumption is the market will fail in the absence of CM by entering a boom bust cycle. Finally, missing money argument assumes that power plants can only earn money by providing energy to the grid.

Economic theory of oligopoly

The oligopolistic economic theory assumes a weak anti-trust environment. Under a weak, anti-trust environment oligopolistic nature of power production investors might delay making investments to deter effects on price OR aggressively invest in a market in order to exercise predatory pricing.

Deadweight loss to consumers

If the market does not meet supply for the grid, the grid operator will be forced to cut supply to a given area. Unfortunately, the cost of lost electricity to a consumer within the same grid may be different. Some consumers, for whom the cost of losing electricity is high, may be willing to pay for low interruption schedule. This lack of realization of potential transaction will lead to a deadweight loss to the economy.

Importance of this issue

The need for CM questions the very ability of Power Exchange to guide the power sector. If CM is needed to run the power market, then it could lead unravelling of the power exchange as we know it. The market will either shift towards bilateral contracts or government intervention like old times. A combination of both the situations is also doable.

Criticism of the Capacity markets

Capacity Markets can be criticized on the basis of actual experience, legal challenges, faulty assumptions and Technical deficiencies. Starting with the actual experience, CM have been implemented in the US and UK. In both the countries, a majority of the CM auctions have gone to old, inefficient firms rather than new plants. Furthermore, Separate legal challenges in UK and US have put a question mark on the legal longevity of the capacity markets.

Then the assumptions for basing CM markets are doubtful. CM markets assume that consumer cannot adapt to the changing power supply. However, many customers in the US and UK can adjust their consumption in various ways. Many retailers provide different plans with different interruption ratios. Moreover, customers now have the ability to monitor their usage easily and adapt habits accordingly. Similarly, the cost difference of Peaker and Base-load power plants is narrowing ever more due to technologies such as Variable Pressure Generators in Non-Renewable Energy and batteries in renewable energy. Similarly, power plants have other potential income streams such as providing services of regulation reserve, responsive reserves and as non-spinning reserves. Lastly, CM implicitly assumes that most outages occur due to lack of power supply when in reality, weather is the leading cause.

CM can also be criticized on the basis of its final impact. First, Capacity Market is expected to level out the energy auction pricing. This reduction in fluctuation will kill incentive to maintain reserve ratio at peak loads. Second CM may become a hinderance towards retiring of old inefficient equipment in favor of new equipment. Third, CM always depends on prediction of system operators which have traditionally erred on the side of over-capacity. This over-capacity can become expensive when doled out via market mechanisms such as CM. Of course, one must also keep in mind that Capacity Markets are a global solution to a local problem.

What to do to avoid the traps of Capacity markets?

Pakistani Power Market can take institutional, regulatory and market-based measures to address the trap of capacity markets. These actions can be classified into measures that are taken before and after establishment of exchange. Fortunately, most of these steps can be taken before the establishment of an exchange.

Before implementing the power exchange, the power sector can implement Demand Management, Connections to regional markets, Price floors, Effective Energy Storage and induction of Variable Load Generation. Pakistan has taken a bold step in this direction with the NEECA Act 2016. NEECA Act 2016 has provisions for mandatory energy audits that will lead to an increase in the value generated from a KWh of power.

Furthermore, DISCOS should be allowed to offer customers different plans with different interruption routines. Such plans would reduce demand for energy without the required deadweight loss. Second, NEPRA should demand generators to provide adaptability profile of Non-renewable power plants as part of requirement to acquire Generation License. Such variability would ensure lesser distinction between peak load and base load power generation. Third, it is very important that the new renewable energy policy includes provisions for storage. The better developed the storage industry the lesser the need for power generation. Furthermore, NTDC should also seek to connect to regional grids. This would allow them to import electricity in time of grid shortage without paying for the capacity payments.

After the Exchange is established, the exchange operator should institute price floors and avoid establishing price ceilings. Not establishing price ceilings would allow market individuals to adapt to high prices.


What is a capacity market?

Capacity Market is simply an auction that sells contracts for providing power on a future date. There are two types of auctions in capacity markets, Base Residual Auctions and Incremental Auctions. Base Residual Auctions are auctions for providing capacity three years from now. While incremental auctions are auctions to trade Base Residual Auctions Tenders before the date of delivery.

Example of a Base Residual Auctions:

Let’s say an auction is happening on 1st September 2019. The auction will happen to provide power on 1st September 2022. A capacity market auctions starts with the auctioneer (usually grid operator such as NTDC) starting with a projection for market demand. Let’s say NTDC decides to auction 5,000 MW of energy for 3rd September 2022. Now assume the following combination of bids was placed.

Company Name

MW of power auctioned for

Auction per KWh






















Here, ENGRO Thar is the most expensive company bidding at 0.9 per KWh. By the rules of the capacity market, the market will clear at 0.9 Rs per KWh. Since 0.9 (Rs per KWh) is the clearing price, all the firms in the auction will receive a clearing price of 0.9. So KAPCO will get a capacity contract at 0.9 Rs per KWh even though they were willing to deliver it at 0.2 Rs per KWh.

Example of Incremental Auctions:

now let’s say KAPCO’s plant is damaged due to flooding. It may sell its contract for providing 223 MW of Power at 0.9 Rs per KWh to other businesses during these incremental auctions.

This proceeds from this contract is then expected to be used to ensure the necessary rate of return for power plants to make investments in the power sector worthwhile.

Why don’t capacity payments exist for other goods?

Capacity payments don’t exist for other consumer goods. Yet, they exist for electricity because of certain physical properties of electricity. The first reason is that electricity cannot be stored and this means that production and consumption of electricity must happen at the same time. A millisecond disruption between demand and supply would lead to blackouts. This balancing act implies that a grid operator has to account for a number of scenarios such as sudden increase in demand or power station failures. Second, the flow of electricity cannot be controlled. Instead, electricity in a patter known as loop flow. This forces grid operator to have a centralized control. Otherwise, a loop flow will overload some lines while underloading other lines.