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Cost-Effective Capacity Markets

In this paper, available on SSRN, we develop a model of a wholesale electricity market with energy and capacity market components to examine the economic relationship between costs and reliability. We investigate the importance of efficient resource accreditation—the amount by which to compensate resources for their contribution to system reliability. We show that "marginal effective load carrying capability," an accreditation method increasingly adopted by system operators, is theoretically optimal.

Applying our model to the PJM system, we empirically assess reliability costs, estimating that current reliability standards implicitly value a potential supply shortage at $54,000 to $77,000 per megawatt hour. Market outcomes are highly dependent on the accreditation methodology; inaccurate heuristics achieve reliability at 0.2 to 171 percent greater cots than the optimal method. By displacing expensive generation resources, improving reliability causes increases in capacity market payments that are largely, but not entirely, offset by decreases in energy market payments.