# <mark>CAPACITY REMUNERATION MECHANISMS</mark>

If resource adequacy and price volatility issues are paramount, and decision-makers are reluctant to use instruments of scarcity pricing and energy-only constructs, alternative market mechanisms are needed to promote resource adequacy, which in most cases take the form of some type of capacity payment. This has been the primary mechanism in several prominent markets, including the forward capacity market in PJM and administered capacity payment mechanisms in some of the cost-based pools in Latin America and the Republic of Korea.

There is significant support in the literature on the need for some form of capacity mechanism to overcome the limitations of the energy-only market. For example, (Cramton & Stoft, 2006) criticized the suitability of the “pure” energy-only approach for driving incentives for investment and operations appropriately. They argue that introducing the missing money must be restored without reintroducing the market power problems currently controlled by price suppression. With a stable functioning capacity market, adequate reliability would be ensured, market power would be reduced, and the risk premium associated with the industry would be minimal. Similar argumentation is provided by (P. L. Joskow, 2006a), where it is stated that <mark>according to data from the US and some other countries, wholesale electricity markets and operating reserves do not provide sufficient incentive to stimulate generating capacity in accordance with reliability requirements. A claim is made that the solution to this problem may be the introduction of well-designed forward capacity markets, which should e</mark> nhance the efficiency of spot wholesale markets and <mark>provides incentives for investing in generating capacity in a manner consistent with operating reliability criteria applied by system operators. The authors echoed the same argument during the</mark> _Symposium on ‘Capacity Markets’_ (P. L. Joskow, 2013) _._ (Cramton & Ockenfels, 2011) describe the forward procurement of reliability options, which refers to physical capacity bundled with the option to supply energy at a spot price above a strike price. This approach aimed to suppress risk and market power, not interfering with real-time price signals, yet providing adequate investment levels.

(Newbery, 2016) argues that although that energy-only markets can potentially provide adequate new investments, hardly any of the necessary pre-conditions hold (at least for the European market case). As in the case of Great Britain, appropriately designed capacity auctions can address the missing money and missing market problem, yet the significant risks of over procurement are still in place. Similar criticism has also been raised for PJM and other US markets with a capacity mechanism as the observed reserve margin has been well in excess of the resource adequacy norms as we discuss later.

(Henriot & Glachant, 2013) <mark>suggest that while VREs may participate in various capacity remuneration mechanisms (CRM), a single regulatory tool may be applied to promote investments in renewable energy sources and ensure adequate levels of capacity. However, the challenge remains with appropriate valuation VREs capacity factor, as being unavailable at the time would produce severe penalties. The issue of cost and distortion due to inconsistent capacity credits for renewables has been analyzed by</mark> (Bothwell & Hobbs, 2017) <mark>. They found that when a producer is compensated based on their marginal contribution to the adequacy and the timing of peak loads is considered, this can lead to optimal utilization of capacity. Finally, (Bhagwat et al., 2017) argue that although energy-only is optimal in theory, capacity mechanisms can be a solution to the situation when imperfect competition conditions prevail, such as imperfect information, uncertainty, a demand shock, or out-of-market interventions.</mark> 15