Electricity markets were originally designed around a simple principle. Generators produce electricity. Consumers buy it. Prices emerge from supply and demand. In theory, that should be enough to ensure reliability.
In practice, it is not.
Across Europe and parts of North America, governments have introduced capacity markets. These are mechanisms that pay power plants not for the electricity they generate, but for being available to generate when needed. At first glance, this seems counterintuitive. Why pay for electricity that is not produced?
The answer lies in how modern electricity systems work.
The missing money problem
In energy-only markets, generators recover their costs through wholesale electricity prices. During normal hours, prices reflect marginal costs. During scarcity, prices are supposed to spike high enough to compensate generators for their fixed and capital costs.
Several economists have argued that, in theory, this system should work. Oren (2003) and Hogan (2005) suggest that if price caps are sufficiently high and markets are competitive, generators can recover investment costs during scarcity periods.
However, real markets are imperfect. Price caps are politically sensitive. Regulators intervene to limit price spikes. Demand is often inelastic. And with growing shares of renewables, conventional plants run fewer hours. As Hach and his colleagues (2016) explain, increasing renewable feed-in reduces load factors and average wholesale prices for conventional generation, while those same plants remain essential for reliability. This creates a structural tension: plants are needed for adequacy but struggle to remain profitable.
Cramton et al. (2013) further argue that renewables aggravate the adequacy problem because they act as near-zero marginal cost generation, suppressing prices and increasing volatility. The result is the so-called missing money problem. Revenues from the energy market alone are insufficient to cover fixed costs.
Capacity mechanisms are designed to fill that gap.
What is a capacity market?
A capacity market is a regulatory mechanism that separates two products:
- Energy, measured in megawatt hours
- Capacity, measured in megawatts of available power
In an energy-only market, generators are paid only when they produce. In a capacity market, generators are paid for committing to be available during future peak periods.
Hach et al. (2016) describe capacity markets as quantity-based mechanisms. The regulator determines how much capacity is required to ensure generation adequacy, often peak demand plus a reserve margin. That quantity is then auctioned. The market determines the price necessary to provide it.
This is fundamentally different from other mechanisms:
- Strategic reserves pay selected plants to remain on standby.
- Capacity payments set a fixed price per megawatt, and the market determines how much capacity enters.
- Capacity markets reverse that logic: the regulator sets quantity; the market sets price.
The design choice matters. A capacity market focuses explicitly on ensuring reliability at minimum cost, but it also increases market complexity by adding a second, interdependent market (Hach et al., 2016).
How capacity markets work in practice
The typical structure includes four steps.
First, the regulator sets a target. This is usually peak demand multiplied by a reserve margin. In the Great Britain case examined by Hach et al. (2016), the regulator sets an under-rated capacity margin, meaning intermittent renewables are often not fully counted toward adequacy.
Second, eligible generators submit bids. These bids reflect their profitability gap. If expected energy market revenues are insufficient to cover fixed or capital costs, generators bid for the difference. If they are profitable without support, they can bid zero.
Third, auction clears. Bids are ranked from lowest to highest, and capacity is procured until the target is met. All accepted capacity receives the clearing price.
Fourth, capacity providers are obligated to deliver or face penalties. The capacity payment is therefore not a subsidy for inactivity. It is a reliability contract.
Hach et al. (2016) compare three scenarios: no capacity market, a capacity market for new capacity only, and a capacity market for both new and existing capacity. Their Great Britain case study finds that a capacity market increases generation adequacy and can reduce the risk of lost load. Importantly, they also show that limiting payments to new capacity only reduces early costs but may create investment distortions later.
The core insight is that capacity markets influence both investment decisions and market prices over time.
The interaction with energy markets
Capacity markets do not replace energy markets. They operate alongside them.
Electricity prices are still determined hourly through merit order dispatch. Hach et al. (2016) model electricity price formation, including ramping constraints, price elasticity, and strategic bidding. When capacity margins are tight, generators can exercise market power and increase markups. A capacity mechanism reduces the frequency of extreme scarcity pricing by ensuring sufficient capacity ex ante.
However, this creates a trade-off. By smoothing scarcity rents, capacity markets may reduce price volatility but increase fixed system costs. Consumers ultimately fund capacity payments through tariffs.
The question becomes whether paying for availability reduces total system cost by avoiding blackouts and extreme price spikes.
Capacity markets and demand response
Capacity markets are not limited to generators. In many systems, demand response can also participate.
Aalami, Moghaddam, and Yousefi (2010) analyze incentive-based demand response programs, including interruptible service and capacity market programs. They model customer behavior using price elasticity of demand and benefit maximization.
In a capacity market program, customers commit to reduce load during system contingencies in exchange for guaranteed payments. If they fail to curtail, they face penalties. This effectively treats load reduction as a capacity resource.
Their model shows that the combined effect of incentives and penalties determines load reduction levels. Higher cumulative incentives and penalties increase participation and peak reduction, assuming linear demand elasticity. Importantly, elasticity values significantly influence effectiveness. If customers are less price-responsive, higher payments are required to achieve the same reliability outcome.
This is crucial for capacity markets. Including demand side resources increases competition in the auction and can reduce clearing prices. It also shifts adequacy from purely supply side investments toward system flexibility.
Do capacity markets improve reliability?
The main policy justification for capacity markets is generation adequacy.
Hach et al. (2016) find that introducing a capacity market increases available capacity and reduces the probability of lost load in their dynamic investment model. They also observe that paying only new capacity lowers initial cost, but paying both new and existing capacity ensures stronger reliability outcomes.
Cepeda and Finon (2013), in related modeling work on capacity mechanisms and wind integration, show that capacity mechanisms can reduce the social cost of large-scale renewable deployment by lowering the probability of lost load.
However, critics argue that properly functioning energy only in markets with sufficiently high scarcity pricing could achieve the same outcome. The debate ultimately revolves around how much price volatility society is willing to tolerate.
The cost dimension
Capacity markets introduce an additional cost component. Consumers pay for capacity contracts on top of energy consumption.
Hach et al. (2016) find that total generation costs may decrease in some scenarios because capacity markets reduce lost load and limit excessive market power during scarcity events. However, outcomes depend heavily on design choices such as:
- Reserve margin levels
- Treatment of existing capacity
- Auction frequency
- Penalty structures
Poor design can lead to over procurement and excess capacity. Under procurement undermines the very purpose of the mechanism.
The renewable transition and adequacy
The growing share of wind and solar intensifies the adequacy question. Intermittent resources reduce average prices and operating hours for thermal plants, yet conventional capacity remains necessary during periods of low renewable output.
Hach et al. (2016) emphasize that required conventional peak capacity does not decline proportionally with renewable expansion. Energy volumes shift, but peak reliability requirements persist.
Capacity markets attempt to manage this structural mismatch. They provide stable revenue streams for flexible plants that may run infrequently but are critical during system stress.
Paying for security
At its core, a capacity market is an insurance mechanism. Society pays for the option of reliability. Some years, that capacity will not be called. Just like insurance, its value lies in availability rather than usage.
Aalami et al. (2010) explicitly describe capacity market programs for demand response as insurance contracts. Participants are paid to stand ready, and penalties enforce credibility.
The broader policy question is whether reliability should be ensured through volatile scarcity pricing or through forward contracts for availability. Capacity markets choose the latter.
Conclusion
Capacity markets are not about paying generators for doing nothing. They are about paying for reliability in systems where energy-only pricing no longer guarantees adequate investment.
As renewable penetration rises, fixed cost recovery through marginal cost pricing becomes more difficult. Capacity mechanisms attempt to reconcile reliability, affordability, and sustainability. Hach et al. (2016) show that properly designed capacity markets can increase adequacy and moderate extreme price spikes. Aalami et al. (2010) demonstrate that demand response can act as capacity, provided incentives and penalties are structured correctly.
Whether capacity markets are the optimal solution remains debated. But the logic behind them is clear. Electricity systems require capacity that may only be used a few hours per year. If markets cannot finance that capacity through energy sales alone, an additional mechanism must.
Capacity markets are one such mechanism. They represent a shift from paying for electricity to paying for security.
References
Aalami, H.A., Moghaddam, M.P., & Yousefi, G.R. (2010). Demand response modeling considering Interruptible/Curtailable loads and capacity market programs. Applied Energy, 87, 243-250.
Cepeda, M., & Finon, D. (2013). How to correct for long-term externalities of large-scale wind power development by a capacity mechanism? Energy Policy, 61, 671-685.
Cramton, P., Ockenfels, A., & Stoft, S. (2013). Capacity market fundamentals. Economics of Energy & Environmental Policy, 2(2), 27-46.
Hach, D., Chyong, C.K., & Spinler, S. (2016). Capacity market design options: A dynamic capacity investment model and a GB case study. European Journal of Operational Research, 249, 691-705.
Hogan, W.W. (2005). On an “Energy Only” Electricity Market Design for Resource Adequacy. Harvard University.
Oren, S.S. (2003). Ensuring Generation Adequacy in Competitive Electricity Markets. University of California at Berkeley.
