Capacity markets are typically financed through consumer charges. Designing charges to be time-variable incentivises consumers to reduce consumption during periods of scarcity, thereby decreasing capacity requirements and increasing consumer surplus.
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Efficient Design of Capacity Market Charges
Time-variable capacity market charges reduce demand during periods of capacity scarcity and thereby lower the need for firm generation capacity by up to 3 GW. At the same time, they increase consumer surplus, meaning the difference between the benefits and costs of electricity consumption for consumers, by around €400 million per year and shift investment incentives towards renewable energy sources.
These are the key findings of the new working paper “The design and implications of demand charges in electricity capacity markets” by Marlene Bröcker, Diana Krainer, Stefan Strömer, and Junior Professor Oliver Ruhnau. The authors are affiliated with the University of Cologne, the affiliated Institute of Energy Economics (EWI), and the AIT Austrian Institute of Technology.
Most European capacity markets use time-variable charges
Germany is currently debating the introduction of a capacity market. Although the costs are expected to be recovered through a charge on electricity consumption, the specific design of this charge has yet to be determined. This working paper compares existing charge designs used in European capacity markets to inform this debate: flat charges, which apply to every kilowatt-hour of electricity consumed regardless of timing or system scarcity, and time-variable charges, which are levied only during a small number of hours.
The analysis shows that most European countries rely on time-variable charges. The most common design is time-of-use, where charges are applied during predefined time windows. In contrast, dynamic charges, which are linked to actual scarcity conditions, have so far played only a minor role. However, current EU State Aid Guidelines stipulate that in the future capacity cost recovery should be concentrated in the 1–5% of hours with the greatest capacity scarcity.
Implications for capacity requirements, consumer surplus, and investment
The study uses a simulation of the German electricity market in 2040 to quantify the effects of different charge designs. Compared to a flat charge, time-variable charges reduce the need for firm capacity by up to 3 GW and increase consumer surplus by around €400 million per year (Figure 1). This is because time-variable charges create incentives to reduce consumption during periods of scarcity while preventing price increases when capacity is abundant. Consequently, the need for firm capacity and the associated costs decrease, while electricity demand outside periods of scarcity increases. Consequently, the modelled optimal investment mix shifts from thermal generation towards renewable energy sources.
Source: Authors.
The model simulation further shows that the differences between time-of-use and dynamic charges with either constant or variable charge levels are relatively small (Figure 1). The results suggest that aligning charges with scarcity and capacity costs is more important than the specific design of time-variable charges.
“The results indicate that time-variable charges can increase the efficiency of capacity markets,” says Ruhnau, Senior Scientist at EWI. “As electrification and digitalisation advance, their benefits may become even more pronounced, as consumers are able to respond more flexibly to price signals.” According to Ruhnau, dynamic charges could even make electrification more cost-effective. For instance, electric vehicles could reduce payments for the capacity markets by avoiding charging during periods of scarcity.
