Understanding the Capacity Market in Power Generation

What, Why and How is Works

In the world of electricity, keeping the lights on isn’t just about having enough power right now—it’s about ensuring there will be enough power when it’s needed most. That’s where the capacity market comes in.

This article is not a call for or against any particular market structure. Rather, it’s meant as an explainer for policymakers, business leaders, and interested citizens to understand what the capacity market is, how it works, and why it exists—especially in the context of a more deregulated energy marketplace.

What Is a Capacity Market?

A capacity market is a mechanism used in some electricity systems to ensure that enough generating resources will be available to meet peak demand in the future—often years ahead. It provides payments to power plants and other resources (like demand response or battery storage) not just for the electricity they produce, but for the promise that they will be available to produce electricity when called upon.

This system is distinct from the energy market, which compensates generators only when they actually supply power to the grid. In other words, capacity markets are designed to pay for readiness, not just delivery.

Why Do Capacity Markets Exist?

In highly regulated utility systems, power plant construction and costs were typically approved and recouped through ratepayer bills. But as electricity markets across the U.S. began to deregulate in the 1990s and early 2000s—particularly in the Northeast, Midwest, and parts of Texas—private developers entered competitive markets where they only got paid when they generated power.

The problem? Power plants are expensive to build and operate, and if there’s no guaranteed revenue unless you’re generating, investors may not build plants that only run a few days per year during heat waves or deep freezes. Yet those plants—often referred to as “peaker” plants—are critical to avoiding blackouts during times of peak demand.

Without a mechanism to reward standby power, the market alone may underinvest in reserve capacity. The capacity market was created to address this risk.

How It Works

In a typical capacity market, such as the one run by ISO New England or PJM (which manages the grid across 13 states and the District of Columbia), operators forecast peak demand three years in advance. They then hold auctions to secure commitments from generators and other resources to be available during that future period.

Winners of the auction—those offering to be available at the lowest cost—receive capacity payments. If they fail to deliver when called upon, they may face penalties.

The capacity market does not replace the energy market; rather, it supplements it by providing a steady stream of income to support resource availability.

When Markets Fail: Lessons from Texas and California

Capacity markets have been controversial, but some point to events in Texas and California as examples of what can happen without one.

Texas’s electricity market, managed by ERCOT, is known for its “energy-only” model—meaning generators are paid only when they produce power. While this approach has kept prices low during normal conditions, it has struggled during extreme events.

During Winter Storm Uri in 2021, widespread outages occurred across Texas as demand surged and generation capacity—particularly natural gas and wind—failed to keep up. Critics argue that without capacity payments, there was little economic incentive for plant owners to invest in weatherization or maintain seldom-used peaking resources.

Similarly, in August 2020, California faced rolling blackouts during a heat wave, in part because resources that were assumed to be available didn’t materialize. Although California uses a different type of “resource adequacy” program rather than a centralized capacity market, the result was similar: the energy-only paradigm fell short during stress conditions.

Pros and Cons

Pros:

• Reliability: Capacity markets help ensure there are enough resources available to meet future peak demand.
• Investment signal: They provide a revenue stream for generators, especially those used infrequently, making it more attractive to build or maintain standby capacity.
• Technology-neutral: Capacity markets can include traditional power plants, storage, and demand response—rewarding flexibility and innovation.

Cons:

• Cost to consumers: Capacity payments are ultimately passed on to ratepayers, potentially increasing bills.
• Over-procurement: Critics argue that capacity markets can lead to more investment than necessary, locking in higher costs and older fossil fuel resources.
• Market complexity: Capacity markets are administratively complex and subject to regulatory intervention, which can affect transparency and predictability.

Conclusion

The capacity market is one of the tools grid operators use to bridge the gap between competitive markets and public need. As more renewables enter the grid and electrification increases demand, ensuring that reliable, dispatchable power is available at all times becomes more important—and more difficult.

Whether one supports or opposes capacity markets, understanding how they work and why they exist is essential to navigating the challenges of modern grid reliability.

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