Capacity mechanisms

In this article, we give a brief overview of how capacity remuneration mechanisms are organised in Europe. We do so by answering the following questions: What is a capacity remuneration mechanism? Why do we need capacity remuneration mechanisms? What are the different forms of capacity remuneration mechanisms? What is the main framework regulating national capacity remuneration mechanisms at EU level? What is today’s role of capacity remuneration mechanisms in the EU? What are the challenges in “futureproofing” capacity remuneration mechanisms?

If you want to dig deeper, our FSR online training on the Evolution of Electricity Markets in Europe might be what you are looking for!

What is a capacity remuneration mechanism?

The aim of capacity remuneration mechanisms[1] (CRMs) is to ensure resource adequacy, i.e. having enough resources (including generators, storage, and demand-side response) available to meet the demand when the system is expected to be most tight. Their objective is to limit the amount of forced consumers’ disconnections (i.e., typically via rolling blackouts) expected in the future. To do so, they remunerate some or all resources for their available capacity, typically through long-term contracts (of 1 year or more).

Why do we need capacity remuneration mechanisms?

In theory, an “energy-only” market would provide the optimal investment signals and ensure resource adequacy. This has been the European target model for electricity markets. However, in practice, policymakers in a number of Member States have introduced CRMs arguing that wholesale markets alone were not bringing forward the required level of investment to ensure adequacy (or provided enough revenue certainty to keep certain power stations online deemed crucial for adequacy purposes). Whether we should continue aiming for the “energy-only” or accept the “energy-plus-capacity” model remains controversial.

Market imperfections, leading to sub-optimal entry or exit of new resources in the power system, are typically argued to be the basis for the necessity of CRMs. In practice, the magnitude, effect, and persistence of such market imperfections is inherently hard to assess and predict. Some have gradually been corrected or mitigated, such as low price caps on wholesale energy markets or interventions by system operators in the functioning of markets (“missing money argument”). Some other imperfections remain and might be harder to remove, such as a lack of long-term contracts (“missing market argument”). These market imperfections are moreover argued to be reinforced in a context of energy transition and geopolitical crises. This includes price, regulatory and political uncertainty, as well as renewable support schemes distortions (e.g. negative prices).

In addition, cost efficiency is not always the only objective of policy-makers or system operators. Electricity remains seen as an essential good, and the consequences of forced disconnections might not be perfectly captured by their economic proxy (the averaged “value of lost load”). As a result, decision-makers might prefer to decrease the probability of such events through a CRM, even though it eventually comes at a higher cost.

What are the different forms of capacity remuneration mechanisms?

The rationale and objective of CRMs differ across Member States, depending on the magnitude and nature of the adequacy issue. As a result, these instruments have been tailor-made to the national systems’ specificities[2]. Today, they take two main forms.[3]

First is the strategic reserve (present in Germany, Sweden and Finland). A few peak generators are placed in a “reserve”, to be activated in case of scarcity. They receive payments to stay available and are excluded from participating in all markets, except under scarcity conditions. This separation from other markets theoretically limits distortions. Moreover, its targeted nature makes it a relatively easy scheme to phase out. An important shortcoming, however, is that the strategic reserve does not incentivise new investments. It is a short-term remedy adapted to temporary adequacy issues by limiting the exit of certain assets deemed crucial for adequacy reasons.

Second is the capacity market (present in France, Belgium, Italy, Ireland, and Poland), which can take several forms. In general, a capacity buyer procures “firm capacity” from capacity providers through regular auctions starting from 4 years ahead of delivery. The capacity market is “centralised” (most common form) when the buyer is the transmission , or “decentralised” (only in France) when the buyers are consumers or retailers obliged to buy capacity certificates to cover their demand. We moreover refer to “reliability options” (Belgium, Ireland, Italy) when the contract that is auctioned off in the capacity market includes payback clauses for high wholesale price periods. The auction can sometimes include locational constraints (Ireland) or be ex-ante split into multiple bidding zones (Italy). The capacity market’s purpose is to provide technology-neutral investment signals. It is, therefore, typically argued to be the most relevant solution for large or maintained adequacy issues. However, there is a risk that payments resulting from capacity markets indirectly distort price signals in other markets, which can eventually lead to local and cross-border externalities. Moreover, hard-to-avoid imperfections in the design, demand definition, and the many administrative parameters can result in significant cost increases for consumers.

The Clean Energy Package (CEP) revision of the introduced the regulatory framework for CRMs in 2019. Member States must first identify an adequacy issue using a Resource Adequacy Assessment following a rigorous methodology. They should then try to address potential market failures through a dedicated implementation plan. If the implementation plan is not enough to solve the issue, Member States should, in priority, consider implementing a Strategic Reserve. If the Reserve is not enough either, another form of CRM can alternatively be implemented.

Capacity mechanisms should respect several overarching principles. One of the most important is the principle of non-discrimination. It imposes that all resources capable of providing the same service should be eligible to participate, including, for example, demand-side, aggregation, and cross-border resources. To avoid a lock-in of carbon-intensive plants, emissions limits are also defined in the Electricity Regulation (2019). Additional guidance on CRM  design was also provided in the State Aid guidelines for climate, environment and energy (CEEAG, 2022).

What is today’s role of capacity remuneration mechanisms in the EU?

CRMs have gained significant momentum over the past years. In particular, capacity markets are already covering 5 Member States[4] representing around 40% of the EU electricity demand. The European Resource Adequacy Assessment (ENTSO-E, 2023) also foresees adequacy issues appearing in new Member States, suggesting the need for additional CRMs.

Moreover, the role of CRMs has been strengthened with the Electricity Market Design reform (EMD reform) [5]. While CRMs were considered a “last resort” and “temporary” measure in the CEP approach, the EMD reform removed these adjectives from the Regulation and recognized that they play a “structural” role in the EU electricity market design. The EMD reform also foresees a streamlining procedure to facilitate their introduction by shortening the approval process.[5] The recognition of their “structural” role, and the facilitation of their introduction, suggests that the role of CRMs might keep growing.

Considering this growing role, CRMs should be made future-proof. This implies reflecting on their compatibility with a future decarbonized electricity system and reflecting on their cross-border interactions.

What are the challenges in “futureproofing” capacity remuneration mechanisms?

In the coming years, we expect that CRMs will further evolve across at least the following four dimensions: decarbonisation, demand response, system services and cross-border aspects.

First, a future-proof adequacy mechanism must be compatible with decarbonisation. This implies avoiding the lock-in of carbon-emissive plants. Today, around 45%[6] of the capacity remunerated from CRMs is fossil-fueled (gas and coal-fired plants). The risk is that while carbon pricing reduces the profitability of polluting plants, CRMs compensate for this reduction and extend their lifetime.[7] The current approach of discretionary emission limits might not be sufficient to decarbonise CRMs, in particular after the EMD reform (2024) which allows for derogations.

Second, CRMs must properly integrate consumers to foster demand response. There are two main options to do so. On the one hand, demand-side response can be allowed to participate explicitly on the supply side of the capacity market to receive payments. Today, this is the main approach, as the regulation mandates demand-side resources’ eligibility. But demand-side participation has remained limited (less than 3% in 2022[8]).  On the other hand, demand-side response can be incentivised implicitly by allocating the costs of the capacity market to consumers proportionally to their demand at the time of system scarcity. This requires allowing consumers to decide on their desired level of security of supply at the moment of the capacity demand definition. Allowing this implicit participation has many theoretical advantages, such as gaining information on consumers’ actual needs, but faces implementation barriers. Today’s capacity mechanisms have not yet adopted this approach.[9]

Third, we might need to evolve from capacity to “system security” mechanisms. Historically, firm capacity was the main scarce resource, i.e., having enough capacity installed that can be switched on when needed. In a future decarbonised system, we can expect that systems become more “energy-constraint” rather than “capacity constraint”, i.e., not having enough energy in storage (electro-chemical, hydro, hydrogen or other) when there are weeks of low renewable generation. In addition, other services such as ramping, inertia and, in general, flexibility might also become scarce. In other words, ensuring long-term security of supply will necessitate procuring new types of services. The EMD reform of 2024 has acknowledged this issue by allowing Member States to introduce “non-fossil flexibility support schemes”, or to redesign existing capacity mechanisms to procure non-fossil flexibility. This raises many design and implementation challenges.[10]

Finally, a future-proof adequacy model must take into account cross-border aspects. When operated at the national level, CRMs can displace capacity from neighbouring energy-only countries. Such externalities are a growing concern because they increase with interconnectivity. Explicit cross-border participation[11] was made mandatory with the hope that it would reduce cross-border externalities, but it might fail to do so[12]. If CRMs become widespread in Europe, a regional approach could become more appropriate. In other words, we could consider gradually integrating capacity markets, as we gradually integrated short-term markets.

Notes

[1] They can also be called simply capacity mechanisms. The two appellations are interchangeable.

[2] For more details on the objective and drivers of the various capacity mechanisms in Europe, you can refer to (Roques & Verhaerghe, 2022) https://academic.oup.com/book/45365/chapter-abstract/389292282?redirectedFrom=fulltext&login=false , and the State Aid Cases approving capacity mechanisms. https://competition-policy.ec.europa.eu/sectors/energy-environment/state-aid-secure-electricity-supplies-sector-inquiry_en

[3] For a broader overview of capacity mechanisms types you can refer to (Noucier & Meeus, 2019), The Clean Energy Package, section 1.4.1.  https://fsr.eui.eu/publications/?handle=1814/64524

[4] For more details on the status of EU capacity mechanisms you can refer to (ACER, 2023). https://acer.europa.eu/sites/default/files/documents/Publications/Security_of_EU_electricity_supply_2023.pdf

[5] For a broader overview of the various changes introduced in this reform, you can refer to our working paper on the topic (Menegatti, Beckstedde, Münchmeyer and Meeus,  Mapping the richness of the electricity market design reform, upcoming working paper).

[6] Due to the relatively limited guidance provided by the regulation and CEEAG, in contrast to the numerous choices possible when designing a CRM (contract type and length, penalty calculation, de-rating methodology, availability checks procedures, etc), the approval processes for capacity mechanisms have been particularly burdensome and lengthy.

[7] Data from (ACER, 2023). https://acer.europa.eu/sites/default/files/documents/Publications/Security_of_EU_electricity_supply_2023.pdf

[8] In Poland for example, the introduction of a capacity market was shown to delay the decarbonisation of the electricity system (Komorowska, 2021). https://www.mdpi.com/1996-1073/14/16/5151#:~:text=The%20analysis%20shows%20that%20the,mainly%20replaced%20by%20natural%20gas. . In addition, capacity mechanisms tend to have an asymmetric effect which favors generators with smaller capital costs, eventually favoring carbon-intensive plants (Mays & al, 2019). https://www.nature.com/articles/s41560-019-0476-1.

[9] Data from (ACER, 2023). https://acer.europa.eu/sites/default/files/documents/Publications/Security_of_EU_electricity_supply_2023.pdf

[10] Under the current capacity mechanisms (except partially under the French decentralized scheme), consumers are never involved individually in the capacity demand definition, and costs allocation methods do not reflect demand reduction efforts in their bill (Rodilla & al, 2024).  https://ieeexplore.ieee.org/document/10158940

[11] For example, whether firm capacity and flexibility should be procured separately or in a single mechanism. Also, system needs are more and more locational which adds a new degree of complexity in the procurement. Future mechanisms could moreover coordinate between generation and grid investments.

[12] “Explicit cross-border participation” means allowing capacity providers from neighboring countries to participate directly in the capacity mechanism to earn payments.

[13] We discuss this issue in our working paper (Menegatti & Meeus, Cross-border participation: A false hope for fixing capacity markets externalities? upcoming working paper).

If you still have questions or doubt about the topic, do not hesitate to contact one of our academic experts:  Ellen Beckstedde, Emma Menegatti, Tim Schittekatte.

Relevant links

Online courses and training:

• Evolution of Electricity Markets in Europe
• FSR Annual Training on the Regulation of Electricity Utilities
• Executive course: Electricity Markets
• The EU Green Deal

Publications:

• Schittekatte & Meeus (2021), Capacity remuneration mechanisms in the EU : today, tomorrow, and a look further ahead https://fsr.eui.eu/publications/?handle=1814/72460
• Topic of the month: Adequacy and Capacity Remuneration Mechanisms https://fsr.eui.eu/adequacy-and-capacity-remuneration-mechanisms/
• Hancher, De Hauteclocque, Huhta, Sadowska (2022) Capacity mechanisms in the EU energy markets : law, policy, and economics
  https://cadmus.eui.eu/handle/1814/75007
• Meeus (2020), The Evolution of Electricity Markets in Europe
• Schittekatte, Reif, Meeus (2020 ed.), The EU electricity network codes
• Bhagwat, Meeus (2019), Reliability options : can they deliver on their promises?
  https://fsr.eui.eu/publications/?handle=1814/61965

Online events:

• FSR Webinar: Capacity Mechanisms in the EU Energy Market: The Launch of the Second Edition Book
  https://www.youtube.com/watch?v=vTHVx-sLX2E
• FSR webinar: Capacity subscription contracts for the electricity markets
  https://www.youtube.com/watch?v=ufDiF6dpEOk
• FSR Insight: Kaisa Huhta | Capacity Mechanisms and free movement in the EU
  https://www.youtube.com/watch?v=Vub_LMoMX4A
• FSR Podcast: The European Commission’s state aid decision on the Belgian capacity mechanism
  https://soundcloud.com/fsregulation-energy-and-climate/podcast-belgian-capacity-mechanism-preview?utm_source=clipboard&utm_medium=text&utm_campaign=social_sharing
• FSR Global Webinar: Navigating Resource Adequacy in Low-Carbon Energy Systems https://fsrglobal.org/navigating-resource-adequacy-in-low-carbon-energy-systems/
• FSR Webinar: The GB Capacity Market Standstill: What is Happening and Why?
  https://fsr.eui.eu/the-gb-capacity-market-standstill-what-is-happening-and-why/