Capacity remuneration mechanisms' taxonomy


Strategic Reserve

In a Strategic Reserve scheme, some generation capacity is set aside to ensure security of supply in exceptional circumstances, which can be signalled by prices in the day-ahead, intra-day or balancing markets increasing above a certain threshold level. An independent body, for example the Transmission System Operator ("TSO"), determines the amount of capacity to be set aside to achieve the desired degree of adequacy and dispatches it whenever due. The capacity to be set-aside is procured and the payments to this capacity determined through a (typically year-ahead) tender and the costs are borne by the network users.

Capacity Obligations

A Capacity Obligation scheme is a decentralised scheme where obligations are imposed on large consumers and on load serving entities ("LSE", further referred to as "suppliers"), to contract a certain level of capacity linked to their self-assessed future (e.g. three years ahead) consumption or supply obligations, respectively. The capacity to be contracted is typically higher, by a reserve margin determined by an independent body, than the level of expected future consumption or supply obligations. The obligated parties
can fulfil their obligation through ownership of plants, contracting withgenerators/consumers and/or buying tradable capacity certificates (issued to capacity providers). Contracted generators/consumers are required to make the contracted capacity available to the market in periods of shortages, defined administratively or by market prices rising above a threshold level. Failure to do so may result in penalties. A (secondary) market for capacity certificates may be established, to promote the efficient exchange of these certificates between generators/consumers providing capacity and the obligated parties or between obligated parties.

Capacity Auctions

A Capacity Auction scheme is a centralised scheme in which the total required capacity is set (several years) in advance of supply and procured through an auction by an independent body. The price is set by the forward auction and paid to all participants who are successful in the auction. The costs are charged to the suppliers who charge end consumers. Contracted capacity should be available according to the terms of the contract.

Reliability Options

Reliability Options (ROs) are instruments similar to call options10, whereby contracted capacity providers (typically generators) are required to pay the difference between the wholesale market price (e.g. the spot price) and a pre-set reference price (i.e. the "strike price"), whenever this difference is positive, i.e. the option is exercised. In exchange they receive a fixed fee, thus benefitting from a more stable and predictable income stream. Under a RO scheme, the incentive for the contracted generator to be available (at times of scarcity) arises from the high market price and from the fact that, if not available and therefore not dispatched, it will have to meet the payments under the RO without receiving any revenue from the market.

The holders of ROs effectively cap their electricity purchase price at the level of the strike price, since whenever the market price increases above this level, the excess will be "reimbursed" through the payment made under the ROs. A scheme based on ROs usually rests on an obligation imposed on large consumers and on suppliers to acquire a certain amount of ROs, linked to their (self-assessed) future consumption or supply obligations, respectively.

Different RO variants can be designed, depending on whether the scheme is purely financial11 or also involves an obligation to have and make capacity available when the option is exercised (or otherwise face a penalty). In this latter case the RO scheme becomes similar to a scheme based on Capacity Obligations.

Capacity Payments

Capacity Payments represent a fixed price paid to generators/consumers for available capacity. The amount is determined by an independent body. The quantity supplied is then independently determined by the actions of market participants.

CRMs within any of these categories may be designed in many different variants, including with respect to:
a) differentiation between different kinds of capacity, and demand side participation;
b) how the eligibility to provide capacity is determined, especially in the case of load;
c) how far in the future obligations are contracted;
d) how the level of (adequate) capacity is determined;
e) how availability is documented or certified;
f) how, in the context of a Capacity Payments scheme, the payment is determined: whether prices are set administratively, according to auctions or in the market. Or, under a Capacity Obligation or a RO scheme, how the threshold/strike price is determined;
g) how the costs are allocated; and h) the rules for the operation and activation of the capacity, including participation in energy markets.

(Source: ACER's anaysis of of 30 July 2013 "Capacity remuneration mechanisms and the internal market for electricity")


The European Commission's consultation from 15/11/2012 to 07/02/2013 on generation adequacy, capacity mechanisms and the internal market in electricity has sparked a discussion regarding the role of State aid rules in the multiple capacity designs flourishing in Europe.
The major European Commission requirements in that regard have been described in Capacity markets vs. Internal Electricity Market – will State aid weapon be used?.
On 15 February 2013 ACER issued an opinion on the need for and the design of the energy capacity markets (see ACER's opinion and particularly interesting figure 1 on page 8 thereof showing the current state of  implementation of capacity remuneration mechanisms (CRM) in the EU Member States (with further differentiation into capacity markets, capacity payments and strategic reserve)).
The scale of the potential needs for efficient capacity markets is underlined by the fact that under the rules of some intended designs the participation in the pre-qualification process is mandatory for all licensed generation that is eligible to participate. Pursuant to architecture prepared by the UK Government this will be enabled via a license amendment implemented by Ofgem (mandatory pre-qualification, however, does not change that participation in the auction is voluntary).
The executive summary of the intended capacity mechanisms laid down in ELECTRICITY MARKET REFORM: CAPACITY MARKET – DETAILED DESIGN PROPOSALS Presented to Parliament by the Secretary of State for Energy and Climate Change by Command of Her Majesty, June 2013 describes the relevant milestones of the UK electricity market reform in the following way:
The UK Government will run the first capacity market auction in 2014 for delivery of capacity from the winter of 2018/19.
The capacity market is designed to cost effectively bring forward the amount of capacity needed to ensure security of electricity supply. It will do this by correcting market failures and providing a predictable revenue stream to capacity providers. The level of revenue will be set through a competitive auction process and in return for payment successful providers must commit to deliver energy when needed or they will face penalties. The capacity market can be described in five operational stages:
a. Amount of capacity: Ministers decide the amount of capacity for which capacity agreements are to be auctioned based on analysis from the system operator on the amount needed to meet an enduring reliability standard.
b. Eligibility and auction:
• The capacity market will be technology neutral and all existing and new forms of capacity will be eligible to participate, except for capacity supported by Contracts for Difference, small scale Feed in Tariffs or the Renewables Obligation, and interconnected capacity.
• Demand side response (DSR) capacity will be eligible, and will be supported by transitional arrangements to develop the capability of the sector.
• Government has amended the Energy Bill so that projects that deliver permanent reductions in electricity demand (EDR) could also participate in the capacity market.
• Eligible capacity providers will offer capacity in a pre-qualification process run by the system operator.
• Pre-qualified capacity will enter competitive central pay as clear auctions also run by the system operator. There will be an initial auction four years ahead of delivery, and a further year-ahead auction
• Successful bidders will be awarded 'capacity agreements', which provide a steady payment for capacity in return for a commitment to deliver energy when required in the delivery year, or face a penalty linked to the value of lost load.
• Existing plants will by default have access to a one year capacity agreement. Existing plants requiring major refurbishment may have access to agreements with a term of up to three years, and longer agreements are expected to be available for new plants.

c. Secondary market:
• Between auction and delivery and in the delivery year, participants will be able to hedge their position through secondary trading.
d. Delivery:
• Capacity providers will receive payment for capacity in the delivery year.
• In return, they will be obliged to deliver energy in periods of system stress and will be financially penalised (following the publication of a capacity market warning) if they do not deliver in stress periods.
e. Payment:
• The costs of capacity agreements will be met by suppliers based on their market share.
• Payments will flow from suppliers, via a settlement body, to providers of capacity.
• Where penalties are applied to capacity providers, the funds will flow from them, via the settlement body, to suppliers.
• The upfront costs of capacity are expected to be offset by reductions in the wholesale electricity price.
Under the UK projected rules the right to exit the capacity market has been also envisioned. It may take place if the underlying electricity market develops sufficiently, particularly through development of greater market liquidity, an active demand side, and more interconnection. The need for a capacity market will also be reviewed every five years.

The System Operator will undertake several roles including providing advice on the level of capacity to auction, administering the auction and issuing capacity agreements.

A panel of technical experts will provide independent scrutiny of the system operator's advice on the level of capacity to auction. Ofgem will be responsible for governance of technical capacity market rules after the first auction has taken place and will continue to regulate the system operator and enforce the rules and competition law within the capacity market.


Settlement agent for the UK capacity  market


The intention to designate Elexon Ltd. as the capacity market settlement agent has been also announced. Elexon will be responsible for:

- The collection and administration of market and participant data relevant to the capacity market
- Calculating and administering payments due to capacity market participants,
- Calculating and administering charges due from capacity market participants,
- Calculating and administering penalties due from capacity market participants,
- Invoicing, collection and payment of the sums owing or due,
- Calculating and enforcing credit requirements where they are due,
- Administration of the governance of the capacity market,
- Collection and administration of bid bonds.


Secondary trading under the UK capacity market

Capacity obligations may be physically traded at any time from a year ahead of the delivery year provided sufficient notice is given to the system operator. The system operator's consent to these trades must be obtained and this will require an assessment by the system operator of the receiving party's eligibility and pre-qualification.
Parties eligible to take on additional obligations include:
• Plant that was unsuccessful in the capacity market auction; and
• New plant that had commissioned early
• Capacity that had not participated in the auction or opted out but that has subsequently been verified by the system operator as providing eligible physical capacity (for instance new demand side services (DSR) or a de-mothballed plant).
Plant that has taken on obligations, opted out or that had declared they would be retiring will not be eligible to take on additional capacity obligations. Plant that has opted out will be able to opt back into subsequent auctions - in which case the system operator will increase demand in that auction accordingly.
Where parties have traded obligations, the capacity payment goes directly to the plant taking on the obligation and the liability in an event is calculated according to the performance of the party taking on the obligation.
The penalties that apply to a new plant that fails to commission (i.e. the loss of the admin fee and the reduction in payment/contract length) will apply to new build even if they physically trade out of their position in the secondary market.
Providers that have acquired capacity obligation pursuant to the auction will not be permitted to take on further physical obligations (even outside of times of peak demand) though they will be able to hedge their position financially in private markets.
The system operator will develop an IT System which will serve as a registry for all capacity obligations and can be capable of becoming a platform for financial trading.
Capacity market's MiFID/EMIR treatment under UK rules

The above-mentioned DECC Capacity Market Strawman brings once more crucial remark when it comes to trading environment of the new capacity market, i.e. that the capacity instruments will most likely not be a financial instrument for the purposes of the Markets in Financial Instruments Directive (2004/39/EC)("MiFID"). Accordingly such instruments would also not be within scope of European Market Infrastructure Regulation (EMIR). UK government also believes that the intended capacity instruments will not fall under the proposed MiFID II new definitions of the multilateral trading facility and  the organised trading facility.



Regulation (EU) 2019/943 of the European Parliament and of the Council of 5 June 2019 on the internal market for electricity (recast), Recitals 45 - 46, 48, 50


Recital 45


Before introducing capacity mechanisms, Member States should assess the regulatory distortions contributing to the related resource adequacy concern. Member States should be required to adopt measures to eliminate the identified distortions, and should adopt a timeline for their implementation. Capacity mechanisms should only be introduced to address the adequacy problems that cannot be solved through the removal of such distortions.


Recital 46


Member States intending to introduce capacity mechanisms should derive resource adequacy targets on the basis of a transparent and verifiable process. Member States should have the freedom to set their own desired level of security of supply.


Recital 48


Capacity mechanisms that are in place should be reviewed in light of this Regulation. (49) Detailed rules for facilitating effective cross-border participation in capacity mechanisms should be laid down in this Regulation. Transmission system operators should facilitate the cross-border participation of interested producers in capacity mechanisms in other Member States. Therefore, they should calculate capacities up to which cross-border participation would be possible, should enable participation and should check availabilities. Regulatory authorities should enforce the cross-border rules in the Member States.


Recital 50


Capacity mechanisms should not result in overcompensation, while at the same time they should ensure security of supply. In that regard, capacity mechanisms other than strategic reserves should be constructed to ensure that the price paid for availability automatically tends to zero when the level of capacity which would be profitable on the energy market in the absence of a capacity mechanism is expected to be adequate to meet the level of capacity demanded.



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