Capacity Mechanisms and Renewable Support Schemes

Learning objectives

By the end of this lesson you should be able to:

Understand why governments intervene in electricity markets to encourage investment.
Explain the purpose of capacity mechanisms and renewable support schemes.
Compare several common policy instruments used around the world.
Understand the trade-offs between market-based investment and government support.
Recognise why investment support mechanisms continue to evolve as electricity systems decarbonise.
Appreciate that policy mechanisms complement rather than replace electricity markets.

Introduction

In previous lessons we explored how electricity markets coordinate the operation of the electricity system.

However, operating today's electricity system is only part of the challenge.

Society also needs sufficient investment to build the electricity system of tomorrow.

New power stations, transmission lines, batteries and renewable generation often require billions of pounds of investment many years before they begin producing electricity.

A central question therefore becomes:

Will electricity markets alone encourage enough investment?

Different countries have answered this question differently.

Many governments have introduced additional policy mechanisms to encourage investment in reliability, low-carbon generation or other strategic objectives.

Why markets may not be enough

Wholesale markets are designed primarily to coordinate short-term operation.

Investors, however, make decisions over decades.

Future electricity prices are uncertain.

Government policy may change.

Technology costs evolve.

Fuel prices fluctuate.

These uncertainties can discourage investment, particularly for projects with very large upfront costs.

Governments therefore sometimes introduce additional mechanisms to reduce investment risk.

Two broad objectives

Most investment support mechanisms pursue one (or both) of two objectives.

Reliability

Ensuring enough generation and flexibility exists to meet future demand.

Decarbonisation

Encouraging investment in low-carbon technologies.

Different mechanisms target these objectives in different ways.

Capacity mechanisms

Capacity mechanisms reward resources for being available when required.

Rather than paying only for electricity generated, they also pay for maintaining reliable capacity.

Resources may include:

gas generation
battery storage
demand response
hydroelectric generation
interconnectors

The objective is to ensure enough reliable resources remain available during periods of peak demand.

Capacity auctions

Many capacity markets allocate contracts through competitive auctions.

Potential providers submit bids indicating the payment they require.

The market operator purchases enough capacity to satisfy a predefined reliability target.

Successful providers receive capacity payments in return for remaining available.

If they fail to deliver when called upon, financial penalties may apply.

Strategic reserves

Some countries adopt a different approach.

Rather than paying all generators for availability, governments maintain a strategic reserve.

These generators remain outside the normal electricity market.

They operate only during emergency situations when normal market resources prove insufficient.

Strategic reserves therefore provide an additional safety margin without directly affecting day-to-day market prices.

Reliability options

Some capacity mechanisms combine availability payments with financial obligations.

For example, providers may receive a capacity payment but agree to compensate consumers if wholesale prices exceed an agreed threshold.

These arrangements encourage availability while protecting consumers from extremely high prices.

Renewable support schemes

Renewable energy projects often face different challenges.

Although wind and solar have relatively low operating costs, they usually require large upfront investment.

Governments have therefore developed various mechanisms to encourage renewable deployment.

Feed-in tariffs

One of the earliest renewable support mechanisms was the feed-in tariff.

Generators received a guaranteed price for every unit of electricity produced.

This provided stable revenues and encouraged investment in emerging renewable technologies.

Feed-in tariffs played an important role in expanding renewable generation in many countries.

However, generous tariffs sometimes resulted in unexpectedly high costs for consumers.

Contracts for Difference (CfDs)

Many countries now use Contracts for Difference (CfDs).

Under a CfD:

A generator agrees a fixed "strike price".

If the wholesale electricity price falls below the strike price, the generator receives a top-up payment.

If the wholesale price rises above the strike price, the generator returns the difference.

This reduces revenue uncertainty while preserving exposure to market signals.

The United Kingdom has used CfDs extensively to support offshore wind development.

Renewable certificates

Some countries require electricity suppliers to obtain a specified proportion of their electricity from renewable sources.

Renewable generators receive certificates for the electricity they produce.

These certificates can be sold separately from the electricity itself.

Suppliers purchase certificates to demonstrate compliance with renewable energy obligations.

Investment tax incentives

Governments may also support investment through taxation.

Examples include:

investment tax credits
production tax credits
accelerated depreciation

Rather than changing electricity prices directly, these policies reduce the cost of constructing new generating assets.

Why do mechanisms change?

Support schemes evolve over time.

As technologies mature:

construction costs often fall,
financing becomes easier,
markets become more competitive.

Many technologies initially supported through generous subsidies eventually compete directly within wholesale electricity markets.

Government support therefore often changes as technologies develop.

Advantages of investment support

Investment support mechanisms can:

reduce financing costs,
encourage innovation,
accelerate decarbonisation,
improve reliability,
reduce investment uncertainty.

Many technologies that are now commercially competitive initially benefited from some form of public support.

Challenges

Investment support also creates important questions.

For example:

Are consumers paying too much?
Which technologies should receive support?
When should support end?
How can governments avoid distorting competition?
How should support schemes adapt as electricity systems evolve?

These questions remain the subject of considerable debate.

The future

The electricity system is changing rapidly.

Future support mechanisms may increasingly recognise not only energy production, but also services such as:

flexibility
fast response
storage
system stability
congestion management
resilience

Rather than supporting particular technologies, future policies may increasingly reward the services that technologies provide.

This reflects a broader transition towards valuing the complete contribution that different resources make to the electricity system.

Bringing the module together

This module has shown that electricity markets are not simply places where electricity is bought and sold.

They are carefully designed institutions.

Wholesale markets coordinate generation.

Retail markets serve consumers.

Network regulation governs natural monopolies.

Capacity mechanisms encourage reliability.

Renewable support schemes encourage investment in cleaner technologies.

Together, these institutions shape how modern electricity systems operate and evolve.

A key insight

Electricity markets alone do not always deliver every objective that society values.

Governments therefore introduce additional policy mechanisms to encourage investment in reliability, decarbonisation and long-term security of supply.

The challenge is to design these interventions so that they complement rather than undermine the efficient operation of electricity markets.

Key takeaways

Governments often intervene in electricity markets to encourage long-term investment.
Capacity mechanisms support reliability by rewarding available capacity.
Renewable support schemes encourage investment in low-carbon technologies.
Common mechanisms include capacity auctions, strategic reserves, feed-in tariffs, Contracts for Difference and renewable certificates.
These mechanisms reduce investment uncertainty but introduce additional complexity.
Support schemes evolve as technologies mature and electricity systems change.
The design of investment support remains one of the central questions in modern electricity market policy.

Looking ahead

This concludes our introduction to the development of electricity markets.

In the next module, we move beyond describing today's market arrangements and begin examining how electricity markets actually determine prices, allocate resources and influence investment decisions. We will explore concepts such as marginal pricing, locational pricing and market efficiency, providing the tools needed to critically evaluate existing market designs and understand proposals for future reform.