Capacity Auctions for New Low-Carbon Power Sources: Japan
In some liberalized power markets, regulators have implemented capacity mechanisms that reward the capability to provide power when the system needs it, on top of payments for actually providing electricity and ancillary services such as frequency adjustment.
Overview
The design of an electricity market determines the revenue streams available for energy projects. In some liberalized power markets, regulators have implemented capacity mechanisms that reward the capability to provide power when the system needs it, on top of payments for actually providing electricity and ancillary services such as frequency adjustment.
Capacity markets are a fairly common mechanism used to improve security of supply in liberalized power systems. Most existing capacity markets award capacity contracts to energy projects via competitive auctions, with the payment typically in currency per unit of capacity (such as US dollars per megawatt per year).
In Japan, the power supply-demand balance became tight over 2021-23 due to a large volume of firm capacity (mainly oil-fired power plants) reaching the end of its technical lifetime and retiring. To increase capacity and support the decarbonization of the country’s power sector, the government announced in April 2023 plans to launch new capacity auctions for new-build low-carbon technologies
The scheme is only available to low-carbon technologies including batteries, pumped hydropower, and thermal power plants to be retrofitted for co-firing ammonia with coal or blending hydrogen with natural gas. For combustion of hydrogen or ammonia at thermal power plants, the program initially accepts fossil fuel-based molecules but requires plant owners to swap those with cleaner molecules over time. The scheme also requires retrofitted power plants to gradually increase co-firing or blending ratios of the molecules, although it doesn’t set specific timelines for these criteria.
Impact
Japan’s new capacity scheme will take a pay-as-bid auction format. Projects with competitive bids will be contracted for a 20-year capacity payment. As a result, capacity auctions should increase long-term revenue certainty for generators, in turn supporting investment in low-carbon power sources.
The mechanism could support the growth of emerging technologies that face uncertain revenue streams, such as batteries, in Japan’s power system. The cap for batteries is 42,000-57,000 yen ($321-435) per kilowatt per year – almost four to six times higher than the UK’s latest auction clearing price.
One caveat in the scheme is that 85-95% of profits from other revenue sources, including from energy and ancillary services markets, must be returned to the auction’s organizers. This is because the goal of the new capacity mechanism is to improve the visibility around long-term revenues to encourage investment in low-carbon firm capacity, not necessarily to increase profitability. Still, the capacity auction price caps are much higher than in other markets to compensate for this profit withdrawal.
Opportunity
BloombergNEF expects that a fleet of low-carbon dispatchable power plants will play an important role in providing back-up to a net-zero electricity system during periods of low wind and solar output. However, these back-up generators face reduced run-hours as the share of variable renewable energy output grows, and therefore an uncertain revenue outlook.
A well-designed capacity market should maintain system capacity sufficient to meet reliability needs, delivering investment signals for new-build power plants when needed, while being cautious to avoid over-procuring. Capacity markets can also support the decarbonization of the electricity mix – for example, by incorporating emissions limits or technology exclusions.