Capacity remuneration mechanisms' taxonomy
pursuant to ACER's anaysis of of 30 July 2013 "Capacity remuneration mechanisms and the internal market for electricity"
In a Strategic Reserve scheme, some generation capacity is set aside to ensure security of supply in exceptional circumstances, which can be signalled by prices in the day-ahead, intra-day or balancing markets increasing above a certain threshold level. An independent body, for example the Transmission System Operator ("TSO"), determines the amount of capacity to be set aside to achieve the desired degree of adequacy and dispatches it whenever due. The capacity to be set-aside is procured and the payments to this capacity determined through a (typically year-ahead) tender and the costs are borne by the network users.
Strategic or ring-fenced Reserves are essentially generating units that are kept exclusively available for emergencies (e.g. when the market is not able to cover demand) and are called upon by an independent body (e.g. the TSO).
The Strategic Reserve is intended to operate only when the market does not provide sufficient capacity and should therefore be dispatched at a price above a reference level signalling scarcity. In theory, the reserve should only be dispatched at a price close to VoLL in order not to interfere with the market even in tight conditions. In this case the natural price formation on the market is not affected and generators receive the same investment incentive as if there were no strategic reserve.
Capacity for Strategic Reserves is procured through a tendering procedure for a specified amount of capacity (in MW), for example on a year-to-year basis. The Strategic Reserve may consist of existing or - provided the auction takes place well in advance of when the contracted capacity should be available - new generation built for the purpose of reserve capacity and may include demand resources. The latter are normally obliged to reduce electricity consumption sufficiently fast to a specified level when called upon. The specification of the amount and type of capacity (e.g. peak units) or demand resources may be based on a so-called reliability study.
The compensation schemes for the providers of Strategic Reserves are specified in the tendering documents and may vary from case to case. These schemes may involve direct payments, payments in the form of an option or mixed forms. Strategic Reserve contracts contain also provisions for notification time, duration of activation, etc.
The costs of the Strategic Reserve schemes are typically covered through system charges included in the transmission tariff. Hence, they are passed on to consumers of electricity. In theory, the revenues, when dispatching the strategic reserves, should cover the costs.
A Capacity Obligation scheme is a decentralised scheme where obligations are imposed on large consumers and on load serving entities ("LSE", further referred to as "suppliers"), to contract a certain level of capacity linked to their self-assessed future (e.g. three years ahead) consumption or supply obligations, respectively. The capacity to be contracted is typically higher, by a reserve margin determined by an independent body, than the level of expected future consumption or supply obligations. The obligated parties can fulfil their obligation through ownership of plants, contracting with generators/consumers and/or buying tradable capacity certificates (issued to capacity providers). Contracted generators/consumers are required to make the contracted capacity available to the market in periods of shortages, defined administratively or by market prices rising above a threshold level. Failure to do so may result in penalties. A (secondary) market for capacity certificates may be established, to promote the efficient exchange of these certificates between generators/consumers providing capacity and the obligated parties or between obligated parties.
The Capacity Obligation creates 'demand' and 'supply' for capacity guarantees. Large consumers and suppliers contract generation capacity corresponding to a certain margin above the volume of their expected consumption or supply obligations, respectively. The margin is applied on top of the consumers' or suppliers' own assessment future consumption/supply obligations. An independent body may set some assessment rules and determines the (reliability) margin.
Large consumers and suppliers can meet their Capacity Obligations by owning generation capacity, by obtaining bilateral contracts with - for instance - generators and/or buying capacity certificates. These capacity certificates are essentially contracts that specify the required availability of an electricity generating plant or part of an electricity generating plant (duration, notification time, etc.). Generators may sell capacity contracts up to the volume of generation capacity that they have reliably available, which is determined by an independent body. Also, demand side resources may be included as interruptible load contracts.
Capacity certificates offer flexibility in the way that large consumers and suppliers comply with their capacity obligation and, if they are standardised, they can be traded on a bilateral basis or in an organised market/auction. In the latter case, the certificate price is determined by the supply and demand in the market/auction.
Capacity providers are paid for the capacity certificates (or bilateral contract) issued; the suppliers pass on the costs of these certificates to their consumers.
Capacity contracted under capacity obligations is expected to be offered into the wholesale market and, in particular, in scarcity situations. Failure to make capacity available results in a penalty.
A Capacity Auction scheme is a centralised scheme in which the total required capacity is set (several years) in advance of supply and procured through an auction by an independent body. The price is set by the forward auction and paid to all participants who are successful in the auction. The costs are charged to the suppliers who charge end consumers. Contracted capacity should be available according to the terms of the contract.
Capacity Auctions are similar to a Capacity Obligation scheme, though the capacity procurement process is centralised and an independent body acts on behalf of total demand. It calculates how much generation (interruptible load) capacity consumers/suppliers require based on the expected total peak demand. The calculations require reliability assessments, i.e. estimates of the total need for capacity including forecasts of peak demand and reserve margins.
Generators may sell capacity contracts up to the volume of generation capacity that they have reliably available, which is determined by an independent body. Capacity certificates can be traded. Suppliers include the cost of purchasing capacity credits in the price they charge to final consumers for electricity e.g. according to their off-take or off-take profile.
Capacity Auction schemes may allow generators and suppliers to procure capacity directly, as under a Capacity Obligation scheme, by means of owning generation, bilaterally contracting capacity. In this case they inform the independent body about their direct procurements outside the auction.
Reliability Options are instruments similar to call options, whereby contracted capacity providers (typically generators) are required to pay the difference between the wholesale market price (e.g. the spot price) and a pre-set reference price (i.e. the "strike price"), whenever this difference is positive, i.e. the option is exercised. In exchange they receive a fixed fee, thus benefitting from a more stable and predictable income stream. Under a Reliability Options scheme, the incentive for the contracted generator to be available (at times of scarcity) arises from the high market price and from the fact that, if not available and therefore not dispatched, it will have to meet the payments under the Reliability Options without receiving any revenue from the market.
The holders of Reliability Options effectively cap their electricity purchase price at the level of the strike price, since whenever the market price increases above this level, the excess will be "reimbursed" through the payment made under the Reliability Options. A scheme based on Reliability Options usually rests on an obligation imposed on large consumers and on suppliers to acquire a certain amount of Reliability Options, linked to their (self-assessed) future consumption or supply obligations, respectively.
Different Reliability Options variants can be designed, depending on whether the scheme is purely financial or also involves an obligation to have and make capacity available when the option is exercised (or otherwise face a penalty). In this latter case the Reliability Options scheme becomes similar to a scheme based on Capacity Obligations.
The key idea of Reliability Options is to rely mainly on the financial incentives to ensure that capacity is bid into the market at times of scarcity.
In this mechanism, consumers - or an independent body on their behalf - buy Reliability Options. Contracted generators, who have issued Reliability Options, pay to the holders of such options an amount, for each unit of energy covered by the option, equal to the difference between the market price and a strike price, set administratively (e.g. by the independent body), whenever this difference is positive. In exchange they receive fixed revenues from the options issued and benefit from a more stable and predictable income. The mechanism may be purely financial, as just described, or a physical element may be included, by requiring contracted generators to make capacity available to the market when the market price exceeds the strike price. In this case a penalty (pen) may be payable, on top of the difference between the market price and the strike price, if the requirement is not met.
Consumers who hold Reliability Options 'implicitly insure' themselves against future electricity extreme purchasing prices (above the strike price). In fact, whenever the wholesale market price exceeds the strike price level, consumers effectively pay only the strike price, as the excess is compensated by the payment received from generators under the Reliability Options.
The volume of the contracts, the strike price and the penalty, if applied, are typically determined by the independent body. The volume of Reliability Options should be equal to the forecasted peak load plus a reserve margin, similar to the case of a Capacity Obligation mechanism. The strike price should be set well above the highest operating (marginal) cost of all units (reflecting a "near rationing" level) in order not to discourage any generator from producing. The level of remuneration for the availability of capacity to generators is in fact the price of the Reliability Options, which is determined on the market. Additionally, the time horizon (for example 7-10 years) needs to be set during which the seller may be required to make the committed capacity available when the market price exceeds the strike price.
Capacity Payments represent a fixed price paid to generators/consumers for available capacity. The amount is determined by an independent body. The quantity supplied is then independently determined by the actions of market participants.
The simplest type of capacity mechanism is to provide direct Capacity Payments. A direct Capacity Payment scheme encourages generators to invest in new or maintain old capacity by complementing the revenues that generators receive from the sale of electricity on the wholesale energy market.
The Capacity Payment is defined and controlled by an independent body. There are different methods of calculating the level of payments and how to target them. For example, the Capacity Payment may apply to all capacity or to existing generation plants only, to new plants, or to specific plant types. Alternatively, it can be differentiated between types of capacity, e.g. between base-load and peak capacity, existing and new capacity, etc.. Demand side resources are typically not eligible to capacity payments.
Generators who receive Capacity Payments for their plants sell their electricity on the wholesale market (i.e. electricity exchanges or bilateral contracts).
Capacity Payments may refer only to the present, but may also apply (exclusively) to new capacity. In the latter case, the payment is explicitly aimed at amplifying the investment incentives for new capacity.
The costs of Capacity Payments are covered by levies collected by suppliers. The fee is typically proportional to the amount of electricity supplied, usually in the form of an uplift charge on energy purchased.