Testing the Performance of a Forward Capacity Market with Barriers to Entry

In the northeastern electricity markets, regulators generally favor keeping spot prices close to short-run competitive levels, and as a result, some generating units with low capacity factors that are essential for reliability may not earn enough to be financially viable. This is the "missing money" problem, and regulators in New England, New York and PJM have introduced some form of capacity market to supplement the earnings of all generators. The rationale for adopting this strategy is based on the implicit assumptions that (1) the mix of different types of generating capacity is economically optimal, and (2) the spot prices really are equal to the true marginal operating cost of generation. The question addressed in this paper is whether the economic incentives provided in a capacity market will give the right incentives to get the right type of new capacity built to make the mix of generating capacity more economically efficient.