Capacity remuneration in power markets: an empirical assessment of the cost of precaution

Authors

Charlotte Scouflaire

Abstract

Because of market inefficiencies, it can be doubtful that the energy only market can ensure an adequate level of security of supply. If market failures have indeed been identified, the resulting deviations from the benchmark model are difficult to quantify. Regulators sometimes implement capacity remuneration mechanism (CRM) as a precautionary measure when security of supply is at risk. Plants then get paid for their very ability to produce in addition to their production. In theory, the remuneration of capacity partially or totally replaces the scarcity rent, reducing the overall price volatility on the market. The market risk is reduced and risk averse agents feel more comfortable investing. Consequently, securing a certain level of security of supply can be cheaper system wide if capacity cost do not offset the benefits of risk and energy prices reduction. Furthermore, any structural shift in remuneration is expected to have distributional effects amongst agents. This paper investigates both the net cost for the consumer and the repartition of such cost among the consumer groups (industrial versus residential). In a panel of 25 states over 24 years with both US states and European countries, a model in difference is used on industrial end user power price dynamics are assessed to set out the net cost of CRM implementation. Indeed, end user pay for the whole supply chain, their prices should reflect the overall system costs. In addition, redistribution effects are investigated using the ratio industrial power prices over residential ones to determine which class of consumer is more affected by the measure. Overall, system costs (by way of end user prices) are statistically unaffected by the CRM implementation. If any, the effect would be downward as in the US: prices have decreased by 1.2% on average. Forasmuch as the measure does not deteriorate security of supply, the financial gain then overweights the financial cost, suggesting a cost efficient internalization of the security of supply externality in the US. The implementation of CRMs also tends to brings residential and industrial end user prices closer one to another, meaning that the residential consumers benefit more from the measure than their counterpart. Considering that the cost of precaution is actually closer to a benefit, there is a dire need to fill the literature gap on CRM efficiency and on dynamics of security of supply demand to settle the argument.