Designing efficient capacity mechanisms: bidding behavior and product definition

Authors

Leopold Monjoie, Fabien Roques

Abstract

In many countries, capacity markets have been put in place to supplement wholesale markets revenues to ensure an adequate generation capacity to maintain security of supply. This paper studies the bidding behavior in those markets and how it can be affected by different capacity product designs. A capacity market allows producers to lock in revenues in advance in exchange for their commitment to being available over a future period on wholesale markets. Producers’ participation depends on the opportunity cost of making the investment available. When the commitment is made, the profitability of the plant is uncertain. The canonical framework is based on a net present value model, where the capacity bid is equal to the expected loss on the energy market. However, this does not recognize managerial flexibility and assumes that the plant cannot react to future market conditions. Thus, we propose a novel approach to conceptualize capacity bids using real options theory, where the opportunity cost is represented as an option on the spread that drives the profitability of the plant. First, we define a bid in a one-period capacity market as a European Put Option. Then, we expand to a multi-period setting in which capacity bids can be evaluated as a modified Basket Option. Our model provides new insights on the interplay between the product/commitment duration and on capacity bid. Using the real options approach, the model presents a first attempt to untangle the different drivers of the opportunity cost for providing capacity availability. We analyze the determinants of the option value concomitantly with the length of the procurement and deduce some policy implications for the product’s design. Finally, we provide a numerical illustration of this issue using data from the French power system.