Cost-Effective Capacity Markets

We develop a model of a wholesale electricity market with energy and capacity market components to examine the economic relationship between costs and reliability. We investigate the importance of efficient resource accreditation—the amount by which to compensate resources for their contribution to system reliability. We use an analytical model to formalize the concept of optimal accreditation in a simplified theoretical setting, and demonstrate that “marginal effective load carrying capability,” a method for measuring resources’ reliability value increasingly adopted by system operators, is an approximation of our theoretical measure of marginal contribution to reliability. Applying our model to the PJM system, we empirically assess reliability costs, estimating that current reliability standards implicitly value a potential supply shortage at $54,000 to $77,000 per megawatt hour. Market outcomes are highly dependent on the accreditation method; inaccurate heuristics achieve reliability at 0.3% to 100% greater costs than the most efficient method. By displacing expensive generation resources, improving reliability causes increases in capacity market payments that are largely, but not entirely, offset by decreases in energy market payments. JEL Classification: D47 Market Design; Q41 Energy: Demand and Supply; Prices; Q40 Energy: General; Q42 Alternative Energy Sources