Energy Infrastructure 19 June, 2017 9:00 am   
Editorial staff

Will the capacity market do its job?

“The decreasing  time of capacity utilization of baseload plants and lack of economic incentives to build new generation capacities, show subsidies are a necessity if units ensuring energy security are to exist”, writes professor Władysław Mielczarski from the Łódź University of Technology.

However, there are a lot of doubts on whether the proposed capacity market system is the best solution.

Dropping capacity utilization time and increasing costs

For a long time a decrease in capacity utilization time has been witnessed. The coal units, whose designed capacity utilization was 6000-7000 hours annually currently work 4000 hours a year (pic. 1). This trend will become stronger because energy production from renewable sources will increase due to EU regulations. If currently renewable energy sources produce 12% of energy delivered to consumers, in 2030 this share will need to increase to 24-25%, because this is the expected participation of Poland in the 27% target of the EU.

Picture 1 Capacity utilization in 2016. Source: Agencja Rynku Energii S.A.

The dropping capacity utilization time increases production cost, which will go up from ca. 240 PLN/MWh from new installations (without the emissions allowance fees) to 300 PLN/MWh, when the capacity utilization will drop to ca. 4000 hours a year (pic. 2). It is hard to talk about economic incentives to build new generation capacities considering the high costs, when the price on the competitive electricity market is currently at ca. 170 PLN/MWh.

Picture 2 Production costs in the function of annual usage of achieved generation capacity. Model designed by prof. W.Mielczarski.

Capacity market proposition

The act which will implement the capacity market was written quite well. It introduces the registration of generation units with a capacity of over 2 MW, and a triple certification requirement. The act and its introduction detail the capacity contracting on Dutch auctions conducted on the basis of the capacity demand curve, whose parameters, which may broadly vary, will be determined by the minister of energy (pic. 3). This is where the first doubt appears. Lack of investments in new generation capacities results from a hard-to-estimate market risk. The question is whether replacing the market risk with regulatory risk, which is even more difficult to gauge, will be an impulse for new investments?

Picture 3 Capacity demand curve. Ministry of Energy “Functional solutions of the capacity market,” Warsaw, 30 September 2016.

The capacity market blueprint identifies five main groups allowed to take part in auctions. It assigns them various roles as either a “price-taker” or “price-maker”. Their parameters, such as maximum and minimum price, will be also determined by a ministerial regulation some day (pic. 4). The categories of Capacity Market Units (JRM) are so different that it is hard to imagine one auction for all of them. The capacity price, which would be determined under such conditions would be way too high for one category and way too small for another.

Picture 4 Price-makers and price-takers. Functional solutions of the capacity market. Energy Ministry, PSE SA, Warsaw, 4 July 2016.

One of the key issues is the time when the first auctions will be held. The schedule of the market implementation is so tight, that even the negotiations that are currently taking place will not increase the possibility of its realization. The time of the first auction will determine whether the 4000 MW capacities currently under construction will be in the “existing JRM”, or the “new JRM” category. Only the inclusion of the capacities that are currently under construction to the “new JRM” category and high capacity prices even at 400-500 PLN/kW_ annually, may save these units from significant financial losses once they enter a competitive electricity market.

Possible auction costs

It seems logical to split the auctions into 3-5 baskets while placing particular emphasis on analyzing three of them:

  • Existing capacities. This category may include a capacity at ca. 10-13 GW, out of which over 60% does not need any subsidies. Subsidies to the tune of 100-200 PLN/kW_ for the rest would be sufficient, considering the group’s high diversity. It would be a mistake to use an auction with a marginal sell price for such a diversified group, because over 10 000 MW of capacity would receive the marginal sell price at the level of 200 PLN/kW_ necessary for one or a few generation capacities, which will significantly increase the market capacity costs and the customers’ burden.
  • Capacities under modernization. This group is estimated at maximally 5-6 GW – mostly older units from the 200 MW unit series. One should ask: how many of those units are worth modernizing, and how many should be replaced with new ones. Despite the fact that this group does not require substantial subsidies – at the level of 230-250 PLN/kW_ – still, it would be a waste to pay for ineffective modernizations. At the same time, it would be very bad if the capacity market subsidies would cause the creation of “monstrosities” in the form of duo-blocks.
  • New capacities. Since a decision on creating a capacity market has been already taken, even though this is not the best way to stimulate new investments, the most attention should be paid to this group. Subsidies at the level of 300-400 PLN/kW_ seem a minimum. Such a subsidy level would allow, in case of a 15-year contract, to sustain Capex at the level of 60-50 PLN/MWh during 40 years of the capacity’s operation (200 000 h/5000h annually). The other issue that needs to be analyzed is: (a) whether to award subsidies for 15 years to a few capacity generations that are simultaneously under construction, or (b) start a construction of about 1000 MW capacity every two years and pay out subsidies once. The second solution would significantly limit the spending of part of the subsidies on interest. Simple calculations of discounted cash flows for a period of 15 years and rate r=WACC=8%, point to the fact that the bankrolling of financial institutions through subsidies through the capacity market can be limited even at the level of 30-40%.

Picture 5 Production costs from new generation capacities for a different level of subsidies from the capacity market. Model designed by prof. W.Mielczarski. Subsidy level: S_200=200PLN/kW_annually; S_300=300PLN/kW_annually; S_400=400PLN/kW_annually.

Two problems still remain:

  • Will the capacity market be approved by the European Commission? The creators of the bill prudently assumed that the financial obligations may arise only after the public help system, i.e. the capacity market, has been notified. And despite the fact that the system has a pre-notification, some doubts persist.
  • The other uncertainty pertains to the attitude of financial institutions, especially considering the known limit for public help for installations, which emit more than 550kg of CO2 per 1 MWh. The Polish banks which have been re-purchased from foreign owners may help in this situation, but it will not be easy.

I am not an enthusiast of a centralized capacity market that is a copy of the English system. However, if we decided to actually go through it, we need to do everything in our power to make sure the system is successfully implemented. Yet, it is always good a idea to have a plan B.