The capacity market debate: What is the underlying market failure?

Investment in liberalized wholesale electricity markets is typically not driven by spot and forward wholesale energy price signals alone. Instead, in most wholesale electricity markets there is a separate mechanism to procure, fund or subsidize investment in generation or demand response capacity. These mechanisms are known as capacity markets and are often highly controversial. There remains substantial debate over whether these mechanisms are necessary and, if so, how they should be designed. This paper provides a theoretical analysis of the capacity market debate. We observe that an intuitive understanding of the effects of capacity mechanisms may be misleading. While a capacity mechanism may offset the effects of a price cap, if the price cap is funded through a levy on consumption the combined effect of the tax and subsidy is to nullify the price cap. We explore possible reasons for under-investment concerns in wholesale electricity markets, focusing on the potential for a lack of liquidity in the hedge market arising from the presence of uninsurable risks. We identify three groups of uninsurable risks and propose policies to address them. • Investment in electricity markets is not solely driven by spot and forward prices. • Most markets have separate mechanisms to fund generation or demand response capacity. • There are ongoing debates on the necessity and optimal design of capacity markets. • Concerns about under-investment may stem from hedge market liquidity issues.