Supply security and short-run capacity markets for electricity

The creation of electricity markets has raised the fundamental question as to whether markets create the right incentives for the provision of the reserves needed to maintain supply security in the short-run, or whether some form of regulation is required. In some states in the US, electricity distributors have been made responsible for providing such reserves by contracting capacity in excess of their forecasted peak demand. The so-called Installed Capacity Markets provide one means of contracting reserves, and are the subject of this paper. Under monopoly as well as under perfect competition, we identify firms' short-run opportunity costs of committing resources in the capacity market and the costs of inducing full capacity commitment. The long-run investment problem is not considered. From a welfare viewpoint, we also compare the desirability of providing reserves either through capacity markets or through the demand side (i.e. power curtailments). At the optimum, capacity obligations equal peak demand (plus expected outages) and the capacity deficiency rate (which serves as a price cap) is set at firms' opportunity costs of providing full capacity commitment.