Capacity Markets

Published: 7/05/2025
Read time: 2 minutes

In today's dynamic energy landscape, a reliable, stable, and secure electricity supply is crucial for businesses across the UK, but have you ever wondered what goes on in the background to ensure there is always enough capacity to meet the ongoing and expanding demand? Well, let us introduce you to the UK Capacity Market (CM). The Capacity Market plays a vital role in balancing supply and demand, supporting the stability of the power grid, and, as we move towards a net zero future, incentivises low-carbon technologies.

In this blog, join Charles Ramsay, Customer Hedging Manager as he delves into the intricate workings of the UK's Capacity Market, examining its objectives, processes and the impact on electricity supply and pricing stability. Whether you're an industry professional or simply curious about how energy markets operate, our insights will provide you with a comprehensive understanding of why Capacity Markets are pivotal in securing reliable and efficient power distribution.

The Capacity Market...

The UK Capacity Market (CM) was first introduced as part of the Energy Market Reform under the Energy Act of 2013. Its primary objective has been to ensure the security of Great Britain's electricity supply by providing predictable revenue streams for capacity providers, encouraging investment in reliable sources of capacity and keeping existing capacity open.
Originally, there were three main policy objectives set out to be achieved. The base target was to incentivise investment, the second was to achieve cost-effectiveness and the final target was to avoid unintentional consequences through minimisation of design risk whilst being able to accomplish decarbonisation goals.

Over the years, the UK government has outlined significant proposals to reform the Capacity Market to ensure it keeps pace with the energy transition and adapts to the increasing proportion of renewable energy in the electricity generation system. Reforms include consulting on new contracts for low-carbon technologies to incentivise their participation in the CM auctions, creating new timelines and requirements for oil and gas generators to reduce emissions from 2034, and strengthening the scheme's ability to deliver security of supply during times of electricity system stress.

This is a highly complex market, ready to be called into 'action' for any stress events when needed - a stress event is where there's a shortage of generation capacity to meet demand. It might surprise you to learn that a capacity market notice (a signal to a possible stress event) is communicated just four hours in advance of when available generation is within a 500MW threshold of NESO's requirement. Let's take a look in more detail at how this market operated and how it successfully balances supply and demand.

Operation: Key steps...

The CM operates through a competitive process where energy providers can secure payments for being available when required. This process helps bring forward the necessary capacity at the lowest cost to consumers, while ensuring cost-effectiveness and price stability and continuing to ensure there's enough electricity during peak demand periods. There are key steps involved in operating the CM including prequalification, auction, agreement management, and delivery:

Prequalification: Before participating in the Capacity Market, potential capacity providers must go through a prequalification process to ensure they meet the necessary criteria. Criteria involve providers being able to provide electricity on demand, or the ability to reduce their demand when needed.
Capacity Auctions: The government forecasts electricity demand and holds Capacity Auctions which occur annually, with suppliers bidding on T-1 and T-4 contracts. Bids are then assessed by National Grid SEO. Contracts are then awarded to those with the lowest price. T-4 auctions secure capacity four years in advance, while T-1 auctions act as a 'top up' to fine-tune capacity needs closer to the delivery year.
Agreement Management: Once contracts are awarded, capacity providers enter into agreements with the government. These agreements outline the terms and conditions for delivering capacity during the delivery year. Providers then receive 'standby' payments to produce electricity when needed.
Delivery Year: During the delivery year, capacity providers must be available to deliver electricity when needed, especially during system stress events, such as periods of high demand and low wind generation.

Auctions...

Once the government has forecasted the electricity demand, it holds Capacity Auctions at the beginning of each year for providers to bid on contracts. There are two main types of contracts, T-1, which matures in one year, and T-4, which matures in four years.

Each auction begins with a capped price set out in the auction guidelines. Each round the price is decreased by a set figure. To leave the auction, each bidder will place an exit bid, which is the minimum price they would accept the capacity agreement. The majority of the contract will then go to the providers with the lowest clear price, with providers then receiving payments to supply electricity when needed.

There are two types of Capacity Market Units (CMUs) that contracts are distributed to, generating and demand side response (DSR). Generating CMUs are existing or new plants or storage facilities capable of exporting power to consumers. Demand side response CMUs involve reducing power demand below a significant level when necessary, such as during seasonal changes. This approach ensures supply meets demand without creating excess electricity.

The most recent T-1 contract auction took place on 20th February 2024, with a clearing price of £36/kW, distributed across 277 CMUs. A week later, the T-4 contract auction was held, setting a record-high clearing price of £65/kW/year for the 2027/28 delivery year, marking a £2 increase from the previous year. This was the first time the T-4 contract had less capacity than the target, falling 700MW short of the 44GW target.

Market Analysis...

The implementation of the Capacity Market has shown benefits over energy-only markets, and even though it's not yet been called into action, its role in securing reliable and efficient power distribution is pivotal, as is its ability to encourage investment and keep pace with net zero and renewables. Let's take a quick look at why...

Reducing Price Volatility: The CM helps to stabilise electricity prices by ensuing that there is sufficient capacity to meet demand, reducing the likelihood of price spikes during periods of high demand or supply shortages.
Supporting Decarbonisation: The CM supports the integration of renewable energy sources by providing a mechanism to ensure that backup capacity is available when intermittent renewable sources, like wind and solar, are not generating power.
Enhancing Grid Stability: By ensuing a reliable supply of electricity, the CM helps maintain grid stability and prevents blackouts. This is particularly important as the energy system becomes more complex with the integration of various renewable and distributed energy resources.
Promoting Innovation and Investment: The CM encourages the development and deployment of new technologies and solutions that can enhance the flexibility and efficiency of the power system, such as smart grids and advanced storage systems.

Although Capacity Markets offer clear benefits, they often come with higher costs than energy-only markets. Capacity payments are usually made monthly or annually, while electricity is sold per kilowatt-hour at market rates. Over capacity risks can lead to unnecessary holding costs, reducing market efficiency.

Final Thoughts...

The UK Capacity Market is an essential component of the nation's energy strategy, ensuring the stability and reliability of electricity supplies in an increasingly complex and renewable-focused energy landscape. By providing predictable revenue streams and incentivising investment in low-carbon technologies, the Capacity Market not only supports the integration of renewable energy sources but also fosters innovation and enhances grid stability. Its role in reducing price volatility and promoting sustainable energy solutions underscores its importance in meeting the UK's long-term energy needs. As we look to the future, the continued evolution and adaption of the Capacity Market will be crucial in achieving a secure, efficient, and decarbonised energy grid. It's worth keeping an eye on government plans for future reform to the CM as this can help businesses make strategic decisions, optimise energy usage, and remain competitive in the ever-evolving economy and energy landscape.

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