News & insights
Date: March 2025 | Sector: Energy | Energy markets | Expertise: Finance and transaction advisory
The capacity market debate: What is the underlying market failure?
In most wholesale electricity markets there is a separate mechanism to procure, fund or subsidize investment in generation or demand response capacity. These mechanisms are known as capacity markets. This paper provides a theoretical analysis of the capacity market debate over whether these mechanisms are necessary and, if so, how they should be designed. The paper, which is available to download for free before 17 May 2025, was written by Darryl Biggar and Mohammad Reza Hesamzadeh and published on 18 March 2025 in the journal, Utilities Policy.
The authors of the paper observe that an intuitive understanding of the effects of capacity mechanisms may be misleading. They suggest that while a capacity mechanism may offset the effects of a price cap, if the price cap is funded through a levy on consumption the combined effect of the tax and subsidy is to nullify the price cap. They go on to explore possible reasons for under-investment concerns in wholesale electricity markets, focusing on the potential for a lack of liquidity in the hedge market arising from the presence of uninsurable risks and identify three groups of uninsurable risks and propose policies to address them.
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