Module 5 — How Electricity Markets Developed
Lesson 6 of 9
Energy-Only versus Energy + Capacity Markets
Learning objectives
By the end of this lesson you should be able to:
- Understand the difference between energy-only and energy + capacity market designs.
- Explain why electricity markets may require additional incentives beyond energy sales.
- Understand the concept of the "missing money" problem.
- Compare the advantages and disadvantages of each approach.
- Recognise why different countries have adopted different market philosophies.
- Appreciate that there is no international consensus on the best way to ensure long-term investment in reliable electricity systems.
Introduction
So far in this module we have explored how electricity is traded through wholesale markets over different timescales.
A natural question now arises:
How do generators actually earn enough money to build and maintain power stations?
The answer depends upon the design of the electricity market.
Around the world, two broad philosophies have emerged.
Some markets pay generators only for the electricity they produce.
Others pay generators both:
- for the electricity they produce, and
- for being available to generate when required.
These approaches are known as:
- Energy-only markets
- Energy + capacity markets
Both seek to deliver reliable electricity, but they do so in different ways.
The challenge
Building electricity infrastructure is expensive.
A new power station may cost hundreds of millions—or even billions—of pounds to construct.
Once built, many costs remain whether the station generates electricity or not.
These include:
- Staff
- Maintenance
- Insurance
- Financing
- Taxes
- Depreciation
Electricity markets therefore need to provide sufficient revenue to recover both:
- operating costs, and
- investment costs.
How this revenue is collected is one of the fundamental questions of electricity market design.
Energy-only markets
In an energy-only market, generators are paid only when they produce electricity.
No payment is made simply for owning a power station or remaining available.
Revenue comes entirely from selling electricity into the market.
If a generator does not produce electricity, it earns no energy revenue.
How does this work?
Imagine a gas-fired power station.
During periods of low demand it may not operate at all.
However, during periods of extremely high demand it becomes essential.
When this happens:
- electricity prices rise,
- the generator produces electricity,
- and earns sufficient revenue to cover both its operating costs and its share of long-term investment costs.
The philosophy is simple:
Periods of scarcity produce high prices.
Those high prices encourage investment.
Scarcity pricing
Energy-only markets rely heavily on scarcity pricing.
When electricity becomes scarce:
- prices increase dramatically,
- consumers are encouraged to reduce demand,
- additional generators become profitable to operate.
These occasional high-price periods provide the revenues needed to justify investment in reliable generation.
Without scarcity pricing, investors may have little incentive to build generation that operates only occasionally.
Advantages of energy-only markets
Supporters argue that energy-only markets have several strengths.
Simplicity
Only one primary product is traded:
electricity.
Strong market incentives
Investment decisions respond directly to market prices.
Technology neutrality
Any technology capable of supplying electricity can compete.
Efficient dispatch
Generators compete continuously based upon their costs.
Challenges of energy-only markets
Despite these advantages, energy-only markets also face important challenges.
Revenue uncertainty
Some generators operate only during rare periods of high demand.
Their revenues can therefore vary significantly from year to year.
Political constraints
Very high electricity prices may be economically necessary to encourage investment.
However, governments often intervene when prices become extremely high because such prices are unpopular with consumers.
The "missing money" problem
This leads to one of the best-known issues in electricity economics.
Suppose scarcity prices are capped to protect consumers.
Generators no longer receive sufficient revenue during periods of scarcity.
As a result, investment may become uneconomic.
This is known as the missing money problem.
The market requires high prices to encourage investment, but society may be unwilling to tolerate them.
Energy + capacity markets
Energy + capacity markets take a different approach.
Generators receive two separate revenue streams.
They are paid:
- for the electricity they generate, and
- for remaining available to generate if required.
The second payment is known as a capacity payment.
Rather than relying entirely on occasional scarcity prices, generators receive more stable income for contributing to system reliability.
Capacity payments
Imagine two generators.
One generates electricity almost every day.
The other operates only during rare winter evenings when demand is exceptionally high.
Under an energy-only market:
the second generator may earn revenue only a few days each year.
Under an energy + capacity market:
it also receives payment simply for remaining available.
The electricity system effectively purchases insurance against future shortages.
Why pay for availability?
Capacity payments recognise an important fact.
Reliable electricity systems require more than energy.
They also require sufficient available capacity to meet peak demand and respond to unexpected events.
Even if a generator rarely operates, it may still provide significant value by being available when needed.
Capacity markets therefore reward reliability as well as energy production.
Advantages of energy + capacity markets
Supporters argue that capacity markets provide several important benefits.
More stable revenues
Generators receive income even during years with relatively low energy prices.
Improved investment certainty
More predictable revenue reduces investment risk.
Reliability
Capacity markets explicitly procure sufficient generation to meet reliability standards.
Reduced dependence on scarcity prices
Reliability no longer depends entirely upon extremely high wholesale electricity prices.
Challenges of capacity markets
Capacity mechanisms also introduce new questions.
Greater complexity
An additional market must be designed and regulated.
Valuing capacity
How much should society pay for availability?
This is not always straightforward.
Risk of over-procurement
Governments may purchase more capacity than is actually required.
Consumers ultimately pay these additional costs.
Technology differences
Not all technologies contribute equally to reliability.
For example:
A battery capable of operating for two hours provides a different service from a gas turbine capable of operating continuously for several days.
Designing fair capacity markets therefore requires careful engineering judgement.
Different countries, different philosophies
Countries have adopted different approaches.
Australia
Australia's National Electricity Market is largely an energy-only market.
Generators recover most of their revenues through electricity sales.
Great Britain
Great Britain combines wholesale energy markets with a Capacity Market that pays generators and other resources for being available.
PJM (United States)
PJM also operates a large capacity market alongside wholesale electricity markets.
ERCOT (Texas)
ERCOT remains primarily an energy-only market, relying heavily on scarcity pricing to encourage investment.
There is currently no international agreement on which philosophy is superior.
The changing electricity system
Historically, capacity markets were often designed around conventional generators.
Today's electricity systems include many new technologies, including:
- batteries,
- demand response,
- electric vehicles,
- distributed energy resources,
- flexible consumers.
Many of these technologies can contribute to reliability without being conventional power stations.
As electricity systems evolve, capacity mechanisms are increasingly expanding to include these new resources.
Looking beyond generation
One important lesson from this course is that electricity systems require many different services.
Energy and capacity are only two examples.
Future electricity markets may increasingly reward additional services such as:
- flexibility,
- fast frequency response,
- voltage support,
- inertia,
- congestion management,
- resilience.
Some researchers therefore argue that electricity markets should move beyond simply paying for energy or capacity and instead reward technologies according to the complete range of services they provide.
This idea will become increasingly important later in the course.
A key insight
Energy-only and energy + capacity markets represent two different philosophies for encouraging investment.
Energy-only markets rely upon scarcity prices to provide sufficient revenue.
Energy + capacity markets supplement energy revenues with explicit payments for availability.
Both approaches seek the same objective:
ensuring enough reliable resources are available to meet future electricity demand.
The difference lies in how those investment incentives are created.
Key takeaways
- Electricity generators must recover both operating costs and long-term investment costs.
- Energy-only markets pay generators only for the electricity they produce.
- Energy + capacity markets pay generators both for producing electricity and for remaining available.
- Energy-only markets rely on scarcity pricing to encourage investment.
- Price caps can reduce investment incentives, leading to the "missing money" problem.
- Capacity markets provide more stable revenues and explicitly procure reliability but introduce additional complexity.
- Different countries have adopted different market philosophies, and there is no universally accepted model.
- As electricity systems become increasingly decentralised, future market designs may reward a broader range of system services beyond simply energy and capacity.
Looking ahead
Wholesale markets operate between generators, traders and large electricity buyers.
Most households and businesses, however, purchase electricity from retail suppliers, who manage these wholesale market risks on behalf of their customers.
In the next lesson, we explore retail electricity markets, examining how suppliers buy electricity, set tariffs and compete for customers.