What Is a Capacity Market?

A capacity market is a mechanism used by certain regional grid operators to ensure that sufficient electricity generation resources will be available to meet peak demand. In a capacity market, generators are paid not just for the electricity they produce, but for committing to be available to produce electricity when called upon, typically during periods of extreme heat, extreme cold, or other grid stress events.

The fundamental problem capacity markets address is that electricity cannot be economically stored at scale, and new power plants take years to build. Without advance planning, there is a risk that insufficient generation capacity will be available to meet demand during critical periods, leading to blackouts. Capacity markets create a financial incentive for generators to maintain existing plants and for investors to build new ones.

How Capacity Auctions Work

Capacity markets operate through periodic auctions, typically held three to four years before the delivery period. The grid operator determines how much total capacity is needed to reliably serve projected peak demand plus a reserve margin. Generators then bid the price at which they are willing to commit their capacity for the delivery period.

The auction clears at the price of the last resource needed to meet the capacity requirement. All cleared resources receive this price, known as the capacity clearing price. A generator that clears the auction receives a capacity payment for being available, regardless of how much electricity it actually produces during the delivery period. If a generator fails to perform when called upon, it faces financial penalties.

Which Regions Use Capacity Markets

In the United States, PJM Interconnection operates the largest capacity market, covering 13 states plus the District of Columbia. ISO New England and NYISO also operate capacity markets. These regions cover the most densely populated parts of the eastern United States, where load growth, aging infrastructure, and environmental regulations have created complex resource adequacy challenges.

Other regions take different approaches. ERCOT relies on its energy-only market, where scarcity pricing during tight conditions is supposed to incentivize sufficient investment. CAISO uses a resource adequacy framework where load-serving entities are required to procure enough capacity to cover their peak demand plus a reserve margin, but without a centralized auction. MISO operates a limited capacity auction that clears at relatively low prices.

The Debate Over Capacity Markets

Capacity markets are among the most debated topics in electricity policy. Proponents argue that they provide investment certainty for generators, reduce the risk of blackouts, and lower the overall cost of reliability by procuring capacity competitively. Without capacity payments, they argue, generators that run only during peak periods cannot cover their fixed costs from energy market revenues alone.

Critics contend that capacity markets suppress energy market prices, distort investment signals, and prop up uneconomic power plants that would otherwise retire. They point out that capacity markets have struggled to keep pace with the rapid changes in the generation mix, including the growth of renewables and storage. The design of capacity markets is continuously evolving, with ongoing debates about how to value flexibility, duration, and clean energy attributes.

Capacity Markets and the Clean Energy Transition

The interaction between capacity markets and clean energy policy is particularly complex. Renewable generators with zero marginal cost can participate in capacity markets but are typically derated based on their intermittent output during peak periods. A solar farm might receive a capacity credit of only 30% to 50% of its nameplate capacity. Battery storage is increasingly competitive in capacity auctions because it can deliver reliable power during peak hours.

Some states have introduced clean energy mandates that operate alongside capacity markets, creating tensions between market-based resource selection and policy-driven procurement. The challenge for market designers is to create capacity constructs that maintain reliability while accommodating the transition to a lower-carbon generation fleet.