Capacity Payments and Supply Adequacy in Competitive Electricity Markets

1 This paper benefited from discussions with Dr. Ignacio PerezArriega of the Spanish Electricity Regulatory Commission who or ganized a workshop on the subject of capacity payment that motivated this work and from the presentations of Larry Ruff and Harry Singh at that workshop. The positions expressed in this paper,however, are the author's own views. 2 Department of IEOR, University of California at Berkeley, Berkeley, CA 94720 USA Oren@IEOR.Berkeley.Edu Abstract: This paper discusses alternative approaches that have been adopted around the world for guaranteeing the appropriate level of investment in electric generation capacity. We argue that the use of "capacity payments" is the least desirable approach that undermines the long-term efficiency objectives of the electric industry restructuring. We explain how in an energy only market, long term supply contracts in the form of call options with premiums that depend on the contracts' strike prices can meet the need for ensuring supply adequacy and the financial health of the generation sector.