Market power and incentive-based capacity payment mechanisms

Capacity markets provide guaranteed payments to electricity generation unit own- ers for having the “firm capacity” to produce electricity. Historically, these markets are plagued by the weak incentives they provide for plants to be available during high-demand hours. The reliability payment mechanism in the Colombian electricity market provides market-based incentives for plants to produce during periods of system scarcity. This market has served as a model for the design of capacity markets in a number of jurisdictions in North America and Europe. We demonstrate severe shortcomings of this mechanism. By adjusting their price and quantity offers, genera- tors with the ability to exercise unilateral market power can choose whether or not a scarcity condition exists. We find that this mechanism can make it privately profitable for a firms to withhold output and create a scarcity condition. We illustrate this prob- lem using hourly data from the first ten years of operation of the reliability payment mechanism in Colombia. The mechanism not only fails to minimize the cost of meeting electricity demand but also creates perverse incentives for electricity generators that could reduce the reliability of electricity supply. We quantify the cost of the perverse incentives caused by this capacity payment mechanism by computing a counterfactual dynamic oligopoly equilibrium for the 2015–16 El Niño event in Colombia.