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There has been a recent clamor in power markets calling for new or revamped capacity “markets” to solve the purported capacity adequacy problem. This article from The Electricity Journal shows that the proponents of capacity markets have the problem backwards—it is not that the market needs to be fixed, but rather that the lack of trust in consumers and the market result has led to the interventions of regulators, politicians, and market officials trying to “fix” the market.

In a functioning market, price performs a central role of rationing existing capacity to those who value it most and signaling the need for capacity investment Together, price signals and demand response restrain price spikes when the system is under stress. This would reduce the political impulse to intervene in markets with measures that erode incentives for capacity investment, which is the economic remedy for price excursions.

In this article, the authors examine the theory of consumer demand and argue that a properly designed demand response mechanism can be relied upon to ration available generation capacity and lead to optimal expansion decisions that eliminate the need for capacity obligations, capacity markets, and administratively determined market prices for capacity. The authors demonstrate that the technology enabling demand response has improved in both cost and performance and that, even if demand-response programs cannot be implemented for all customers, capacity adequacy can be addressed through targeted programs involving the largest customers.

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