Capacity markets a barrier to cutting emissions, research paper argues

The introduction of capacity markets has a skewed effect on investment in the electricity sector, disproportionately rewarding fossil fuel generators at the expense of renewables, a new research paper has argued.

The paper authored by researchers from the Northwestern University and staff from the Federal Energy Regulatory Commission was published in the journal Nature Energy this week.

The paper has argued that capacity markets overwhelmingly reward power stations with the cheapest construction costs and have little regard for operating costs, the flexibility of supply or the impacts of greenhouse emissions. Its release comes as capacity markets are considered as a future tool in Australia.

“In the US, most electric power system operators put a cap on energy prices and use capacity payments to ensure ample supply of generation resources,” report author David Morton of Northwestern University said.

“Our paper shows that such practices inadvertently favor natural gas generators and discourage investment in renewable resources such as wind and solar power.”

Under a capacity market, power stations are paid on the basis of guaranteeing that a certain amount of electricity generation capacity will be available to the market. They effectively work as an insurance policy for the energy market, to ensure an adequate supply of electricity is always accessible to the market.

The researched modelled the response of energy markets to the introduction of a capacity market mechanism, finding that they incentivised investment into generators with ‘low fixed costs and higher operating costs’ and could work as an impediment to the decarbonisation of the electricity system.

“The majority of energy in low-carbon systems is likely to be provided by some combination of hydroelectric, nuclear, wind and solar resources, all of which are characterized by high capital costs and low operating costs,” the study concluded.

“Accordingly, capacity markets as currently structured may work against efforts to decarbonize.”

In the paper, the researchers said that capacity markets were “ill-suited to financing low-carbon resources” and instead would support investment in peaking generators, especially gas generators.

“The higher a unit’s operating costs, the more its cost recovery in an energy-only market relies on scarcity prices,” the authors said.

“Therefore, the introduction of a capacity market has a stronger impact on the risk profile of technologies with higher operating costs.”

The introduction of a capacity market has been flagged as a potential reform to the National Energy Market, as the market operators seek ways to incentivise investment into new firming capacity in the market.

The Energy Security Board is currently undertaking a view of the National Electricity Market and will deliver recommendations to the COAG Energy Council on how the Australian energy market may be reformed to bring on investment in new firm and flexible generation capacity as coal-fired generators reach their retirement age.

The review has been prompted by continued claims from the energy market participants, along with several state energy ministers, that the current electricity market regime in Australia is no longer fit for purpose.

Several energy companies have advocated for a capacity market, including AGL Energy, which has seen a capacity market as a potential way to keep ‘baseload’ generators in the market for longer.

The Western Australian electricity market, which operates independently from the energy market in the eastern States, incorporates a capacity market mechanism that has attracted criticism. It has faced claims of causing over-investment in unneeded generation capacity. Some generators that have been financed with capacity payments have never been switched on.

The research paper reaffirms the view that the introduction of capacity markets would likely slow efforts to decarbonise the energy system, with the authors finding capacity markets were poor at identifying and incentivising electricity supplies with low marginal cost and a low emissions footprint, such as wind and solar.

“An increased reliance on existing capacity market structures without the emergence of other forms of risk trading is likely to work against technologies with low operating costs, a category that includes all of the most scalable forms of low-carbon generation,” the paper said.

The research substantiates the warning that was issued by Sara Bell of the UK-based demand response company Tempus Energy, who recently told the All Energy conference that capacity markets were an effective subsidy for fossil fuel generators.

“I think it is impossible to create a capacity mechanism that doesn’t it become a fossil fuel subsidy scheme. We legally challenged the UK capacity market under competition law. Basically our legal argument was if customers can do this cheaper, why the hell are we subsidising fossil fuels?” Bell told the conference.

The Energy Security Board is expected to deliver its recommendations on a post-2025 design for the National Electricity Market in 2020.