What are capacity payments?

In the current Irish electricity market, generators are paid for the energy they produce and they also receive a payment (a capacity payment) for being available to produce. Capacity payments are set at a level to ensure that sufficient generation capacity is available to meet the demand for electricity at all times. As a proportion of their total income, wind generators receive least through capacity payments – and peaking plant, that are needed only occasionally, receive the most.

Capacity payments are one of the means by which All-Island Single Electricity Market (SEM) Committee ensures that the Irish electricity market incentivises new investment in electricity generation. In 2014 the aggregated (total) payments made to generators for the electricity sold into the Irish market came to €2.2 billion ¹. In addition to this generators received capacity payments of €565 million (increasing by 1.6% in 2015) ². The annual capacity payment sum for 2016 is set at €515 million, and relates to a capacity requirement of 7070MW ³. The capacity payment sum is down 10% on the 2015 total.

For generators, the capacity payments are uniform for each half-hour trading period, i.e., the same price is paid to all. The capacity price varies by trading period however and at times of lower margin the price will be higher and therefore the overall price achieved by a generator will depend on the timing of its availability. If it generally tends to be available at times of high margins it will be paid less overall. Generators with priority access such as renewable energy and ‘price takers’ with price guarantees receive the lowest proportion of their revenue in capacity payments. Capacity payments accounted for between 7% (for wind) and 30% (for peaking plants) of generators’ revenue in 2013.

Generators receive capacity payments whether or not they produce. In this sense the payments operate like an insurance policy to make sure we can produce electricity when needed. They are a key aspect of the electricity market design whereby the wholesale price of electricity is set at the price at which the last plant to be dispatched has bid in – the market clearing price.

The decision to have capacity payments is influenced by the priority the regulator attaches to security of supply and to the likely effects on the cost of capital to power generators. The Irish electricity system is relatively small and without capacity payments could result in a boom-bust cycle of investment leading to oversupply and subsequent underinvestment. This cycle has deliberately been smoothed by the system of capacity payments derived from the cost of the ‘best new entrant generation’.

In our electricity market the Commission for Energy Regulation (CER) has the responsibility to ensure that the lights stay on and that there is fair competition between generators. In designing the Single Electricity Market (SEM), and in setting the rules under which generators compete, the CER and the Utility Regulator, its counterpart in Northern Ireland (NIUR), created incentives including capacity payments to attract investment in new plant. To the extent that this is achieved efficiently, the cost of capital for investors is reduced and electricity prices will be lower. Capacity payments are set to reflect the cost of a “best new entrant” to encourage investment in new plant that will displace ageing or higher-cost plant ⁴.

When the SEM came into being in 2007, the market arrangements including the capacity payments system that the Regulatory Authorities (CER and NIUR) put in place succeeded in attracting new investment. A new CCGT power plant went into operation in Great Island, Co. Wexford by the ESB and Bord Gais in Cork in 2010 ⁵. Bord na Mona provided peaking generation at its Edenderry site. Arrangements for demand side bidding to reduce electricity demand at times of high prices was facilitated on behalf of customers.

Looking forward, the Irish electricity market is undergoing reform. The EU is working to harmonise electricity markets by specifying a target model across Europe whereby the SEM will be replaced by a new integrated-SEM (iSEM) which will be compatible with EU requirements by 2017. Under the proposed system of capacity payments, generators will compete to sell reliability options. Consumers will remunerate the successful generators and, in return, receive assurance that there will be sufficient generation plants installed on the system to meet the maximum demand ⁶,⁷.