It’s January 2030. The EU has met its aspirational goal of 45% renewable power. The IEA’s prediction has proved accurate, and energy demand has doubled since 2025, fueled in part by growing demand for AI data centers. Europe is facing a prolonged period of Dunkelflaute – or cloudy, windless days.
Will market forces ensure energy supplies meet surging demand for heat and light while powering the digital economy, or do we need a system that pays suppliers to have reserve capacity on hand, just in case we need it?
This question is at the heart of the current debate around capacity markets and whether they are the most effective way to ensure future resource adequacy.
There are valid arguments on both sides of the discussion, many of which reflect the energy trilemma: the best way to balance sustainability, affordability, and security of supply.
But first, let’s look at why capacity markets have become such a hot topic.
Energy-only markets (EOM) - An alternative to capacity markets?
EOM arrived in the 1990s alongside the onset of liberalized energy markets. Before then, vertically integrated, often state-owned power companies generated, transmitted, and supplied energy to all end users. It was a centralized, top-down model where forecasting was relatively straightforward and conservative safety margins were routinely built in.
Supply and demand determine energy pricing in EOM, with energy available at a fixed or more predictable price through long- and mid-term trading, while short-term adjustments are made on the more volatile day-ahead or intraday/real-time markets. According to the IEA, 90% of energy traded in the European market is mid-term, categorized from a few months to 3 or 4 years ahead.
Even with advanced analytics, it’s hard to accurately predict future energy demand, and grid operators may need additional power at a moment’s notice from the short-term markets. If there’s increased demand or loss of supply, prices spike, with higher prices ultimately passed on to end users in their utility bills.
As a result, many governments and national energy regulators have introduced price-capping systems to ensure operators can access resources and provide a reliable energy supply at a consistent, affordable price.
For instance, Great Britain brought in domestic energy price caps in 2018, since when the domestic retail market has, at times, been loss-making. The government has introduced various mechanisms to help suppliers recoup losses at times of market instability. More recently, in the 2022 ‘Iberian Exception’, the EU agreed to let Spain and Portugal bring in price caps, in order to shield consumers from soaring energy prices following Russia’s invasion of Ukraine.
Why were capacity markets established? Follow the ‘missing money’
Price caps interfere with market forces, reducing revenue for generators. This can potentially make operations financially unviable due to the ‘missing money’ – the price suppliers could receive for their energy during price spikes.
At the same time, fossil fuel-powered plants with fixed operational costs may also become economically unviable when renewables take a greater share of the energy mix. As energy costs decrease, traditional plants may be used only when demand peaks or there is insufficient wind or sun for renewables. In these circumstances, operators may struggle to find investment for new or replacement capacity.
Operating alongside the energy markets described above, capacity markets aim to plug these gaps, paying generators to be ready to supply energy, even if it isn’t needed.
While there are various systems, generally suppliers submit bids in a centrally run auction. Auctions may include renewable or fossil fuel generation, Battery Energy Storage Systems (BESS), and in some markets, demand-side response through aggregators or large Commercial & Industrial (C&I) consumers.
The successful (read: lowest) bidders are paid to maintain the agreed-upon capacity on standby, often years in advance, whether or not it is eventually utilized.
A looming capacity crisis?
Energy demand is predicted to grow substantially in both Europe and the U.S., with the EU predicting a 60% increase in consumption between 2023 and 2030. There is growing concern that more planning will be needed to meet this demand.
There are 3 key drivers for growth:
Decommissioning of fossil fuel plants: The EU’s Net-Zero by 2050 target means that gas, oil, and coal plants will be largely phased out, with coal plants in countries such as Poland becoming increasingly unprofitable as the share of renewables increases. Some countries, including Switzerland, have also committed to phasing out nuclear power plants.
Electrification: As the energy transition accelerates, electrification will increase demand for the heating, transport, and manufacturing sectors.
Growing the digital economy: Fueled by the growth in AI, the energy to power the digital economy is predicted to rapidly increase, with data centers expected to consume 9% of all power generated in the U.S. by 2030, more than double the load in 2023. In Austria, Greece, Finland, Hungary, Italy, Portugal, and Slovakia data center consumption is projected to increase between three and five times by 2035.
Can energy-only markets meet future capacity demands?
It’s this rapid growth, combined with market volatility driven by geopolitical factors, that has made this debate so hotly contested now.
With so much uncertainty, will EOM and market forces be sufficient to meet our future energy demands, or do capacity markets enable the planning that’s needed?
The arguments for and against capacity markets align with the three elements of the energy trilemma – how to balance the competing goals of security, cost, and sustainability.
Security and capacity markets
The arguments for
Energy security is a primary driver for capacity markets. The war in Ukraine highlighted the risks of relying on imported energy, a particular concern for Germany, which had been heavily dependent on cheap Russian gas.
The EU has responded with plans to build the region’s energy security by increasing renewable power and developing a more integrated grid.
In a system powered by intermittent renewables, if demand increases unexpectedly, or if there is a prolonged period of cloudy, windless days, capacity markets offer the reassurance of reserve energy supplies.
Some advocates argue that introducing a capacity market also forces stakeholders to clearly define what this resource adequacy should be, using data-driven analysis.
The arguments against
Critics argue that capacity markets are an unnecessary intervention in liberalized energy markets, distorting price signals and stifling innovation that could provide secure supplies. Some question whether the system does actually offer the security it promises when future energy demand is so uncertain:
- One concern is that the fines imposed on suppliers who breach their agreements may be too low. In theory, it may be more profitable for a supplier to sell energy in short-term markets and take the penalty.
- Suppliers may be unable to supply the agreed energy when called upon. This happened in the U.S.’s largest capacity market, PJM, during Winter Storm Elliot. In December 2022, freezing temperatures led to widespread power plant outages, with many suppliers failing to meet their capacity obligations.
- Boosting energy security is a key driver behind Europe’s push towards more interconnected energy grids. However, this could be undermined if some regions switch to a capacity market while others stay with EOM. Capacity contracted to be held in reserve may no longer be available for short-term trading in neighbouring EOMs when needed, distorting cross-border trading.
Cost and capacity markets
The arguments for
In a liberalized energy market, unforeseen increases in demand and/or market volatility lead to higher energy prices. Consumers may see spikes in their energy bills as a result. This is a key driver behind Germany’s current proposed introduction of a capacity market.
Capacity markets are often seen as expensive, as the additional costs for reserve capacity are ultimately passed on to end-users. However, when it comes to capital investment, they may even deliver cost savings. The certainty that capacity payments bring is attractive to investors, helping to reduce costs. For example, research comparing capacity markets and EOM in Poland found that a capacity market could potentially cut electricity bills long-term.
The arguments against
- Critics argue that the system is prone to expensive overcapacity, with suppliers being encouraged to build plants that may remain idle.
- EOM can lead to more efficient use of resources, with the market closely following supply and demand. This can be especially useful in systems with a higher proportion of renewables, where flexibility is a significant advantage.
- Price spikes can also be a problem with capacity markets if connection queue backlogs limit the supply of future capacity submitted for auction, driving up capacity prices. This affected PJM, a U.S. Regional Transmission Authority (RTO), in its 2024 auctions, with cleared prices up tenfold for 2025/2026 capacity.
Sustainability and capacity markets
The arguments for
The extent to which capacity markets support renewables and storage depends on the technologies included in auctions. Increasing the amount of BESS can help to integrate renewable energy into the market.
While nuclear and gas are clear winners in Great Britain’s capacity market, BESS won nearly 17% of the total in the most recent T-4 auctions. The country is currently examining ways to enhance the operation of consumer flexibility in auctions, including demand-side response.
Once operational, the winner of one 15-year contract will be Great Britain’s largest battery project, demonstrating how capacity markets can support renewable generation and storage investment.
The arguments against
- Capacity markets can stifle innovation and hamper the energy transition. Traditional fossil fuel plants can guarantee reliable resources years in advance, a task that’s more difficult for intermittent renewables.
- Capacity payments may sustain traditional fossil fuel power plants that might otherwise be decommissioned, even if the energy produced is more expensive than that from renewables.
- Competition in an EOM incentivizes suppliers to offer energy at the lowest cost, encouraging innovation and technology that may be missed in a capacity market.
- EOMs rely on real-time energy pricing insights, which foster innovations such as advanced forecasting, demand-side flexibility, and aggregators.
Data is the common factor
Balancing energy security with costs to consumers, while shifting to a system powered by intermittent renewables, is no easy task. It has become even more challenging in an uncertain global environment, and no one knows precisely how much energy will be required for electrification and to power AI-driven transformation.
Are capacity markets the best way to prepare for future demand and ensure we have the necessary investment for resource adequacy? Or do we risk hindering the transition to renewables and increasing prices for consumers?
We don’t presume to have the answer to this tricky question. However, one thing is sure: access to and visibility of data will be vital. Whether it’s mapping and monitoring energy generation capacity across grids or matching supply and demand in real-time, advanced analytics and forecasting will be critical, whichever market structure is selected.
Image of National Grid Control Centre in Wokingham thanks to DECCgovuk.
