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What is Capacity and Why Should I Care?

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To begin this discussion, we should first define a couple of important terms connected with electricity markets and how people consume electricity. The first term is energy. Energy is the amount of electricity that customers consume over time. It is produced by generating plants and delivered to businesses and homes over the utility wires. Capacity is the physical ability of those same generating plants to produce the energy that is delivered to those same businesses and homes.

To differentiate between the two, consider if you had a 100 watt light bulb in your lamp lighting your office.  The 100 watt label means that whenever that bulb is turned on, it is placing a 100 watt capacity requirement on the electrical system and a generator somewhere needs to be able to supply that 100 watt demand.  If you have that light on for 10 hours, you will consume (100 Watts X 10 hours)  1000 Watt Hours (or 1 Kilowatt hour) of electrical energy.

Now, why should you care about capacity?  

Simply put, if there are not enough generating plants capable of supplying the collective capacity needs of the region where you live or where your business resides, then the electrical reliability in your region will be degraded.  If a capacity shortage is bad enough, then there could be localized electrical outages or brownouts.  The good news is that the Regional Transmission Organizations (RTOs) that manage the wholesale electric grid take capacity needs very seriously and in fact have to manage the capacity needs of their regions to maintain federally mandated reliability requirements.  To do that, the vast majority of the RTOs in North America administer what are called capacity markets

Capacity markets are designed to assure that there is sufficient generating capacity in the future to meet the capacity needs of the region, plus what is called a reserve margin.  Market designs vary, but the common elements are that generation owners receive a capacity payment to assure that their plants are available in the future to meet the capacity needs of the region.  These payments are separate from the energy payments that generators receive when they generate electricity and place the energy onto the electric grid.  

If there is more generation capacity available in a region than is necessary to meet the needs plus the reserve margin, then capacity prices can be relatively low.  If the reserve margin begins to dwindle, then capacity prices will begin to rise.  When generators see that price rise, then they will be incented to build new generation in the region, the reserve margin will be restored and reliability will be maintained.

The cost of capacity on customer energy bills is overall very low, which makes it all the more perplexing that how to correctly structure capacity markets and payments receives more news coverage than practically anything else in the industry.  That is because, at least in the organized markets, these payments are not intended to be fixed but merely to provide what is called the “missing money” from energy payments.  Energy payments do not cover all the fixed and variable costs associated with running a power plant because of price caps.  Therefore, capacity payments are supposed to be additive to energy payments to ensure that over a period of time, generators will be able to cover their variable and capital costs, as well as receive a reasonable return on their investment.   Thus there is plenty of room to disagree on what is reasonable, what is the “missing money” and what exactly are you paying for – a plant to be able to provide energy 24 hours a day, or during peak periods, etc.  These are important questions, many of which are subject to on-going rule development at the RTOs and acceptance by the Federal Energy Regulatory Commission.  

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Posted: May 13, 2015