Developing a Capacity Payment Mechanism in Italy

14 November 2003
By Hamish Fraser and Dr. Francesco Lo Passo

The Italian electricity system is in urgent need of capacity, as shown by blackouts that affected residential customers at the end of June 2003 and by the emergency plans established by the Transmission System Operator in July. Unlike the blackout in the US Northeast, which was caused by transmission system problems, the Italian blackouts occurred because there simply isn’t enough generating capacity. Given available capacity and peak demand, the resultant margin for Italy has proven to be insufficient to cover the system needs.

Ensuring security of electricity supply is very important to every economy. The Government of Italy is moving to fix the Italian problem with a capacity payment scheme. Numerous capacity schemes have been developed and implemented around the world in the past few years. Some have been failures; others appear to be successful. Each addresses a specific set of problems of the country or region concerned, and none of them were designed with Italy's exact situation in mind. Italy cannot afford to use a "cookie-cutter" approach which simply adopts a model from somewhere else, but needs a scheme designed for Italian conditions.

In this article, NERA Special Consultant Hamish Fraser and Director Francesco Lo Passo maintain that Italy needs to promote long-term investment in electricity generation and the market framework must provide a reasonable prospect of cost recovery. To achieve this aim, it will be important to devise an objective and transparent scheme.

The authors briefly highlight two possible ways of implementing a capacity scheme in Italy: (i) a capacity obligation method; (ii) a capacity price method. In the former case, central planners predetermine a quantity obligation and let the market determine the price of capacity. In the latter, the market is left to determine how much capacity will be built, given the predetermined price.

The decision on the scheme to choose -- whether based on quantity obligations or payments to units of capacity -- should rely heavily on which one will work best in Italy. The adopted scheme should allow generators to recover the full value of capacity, i.e. the annual fixed costs of the marginal plant.

This abstract is republished with permission from the Electricity Journal, Volume 16, Issue 9, November 2003, Copyright (c) 2003 Elsevier Science, Inc., All rights reserved.