Independent System Operators (ISO) and Regional Transmission Organizations (RTO) operate real-time and day-ahead markets to ensure there is enough power supply to meet demand on the grid for today and tomorrow.
For long-term grid reliability and to secure sufficient generation capacity to meet future load increases, ISO and RTO also operate what is referred to as the capacity market.
The capacity market provides key benefits to the electricity market, including:
Capacity represents a resource commitment to delivery into grid when demand surges or in cases of emergency.
Typically, less economical generation resources do not get dispatched 100% of the time. The remaining capacity, though not utilized, provides insurance to meet additional load which is critical to grid stability.
In each market, based on the predicted load and available generation resources, a regional reserve is usually required by the ISO/RTO to act as the safety net.
Suppliers can either choose to build additional capacity themselves in the physical market or they can invest in the auctioned capacity market to meet the reserve requirement.
Take NYISO as an example. Their Installed Capacity Auction Program (I-CAP) consists of three auctions:
The Spot Auction - A mandatory auction where Load Serving Entities (LSE) can procure their capacity requirements and offers to sell in the upcoming obligation month only. The spot auction is based on demand and supply dynamics which serve as investment price signals. The capacity clearing prices are established based on sloped ICAP Demand Curves. Spot auctions are run two to four days prior to the start of each month.
The Monthly Auction - A voluntary auction which covers any month in the capability period. Auctions are held at least 15 days prior to the start of each month.
The Capability Period Auction - Also known as known as Strip Auction, it allows LSEs to procure capacity for six-month terms at a single price. CME Group offers a secondary capacity futures market that provides a forward financial exposure to the auctioned capacity for up to five years. These products equip customers with tools to manage their long-term capacity exposure and provide an essential market place for forward price discovery, risk management and central clearing.
Based on its long-term future load prediction and current NYISO requirement for reserve margin percentage, this LSE estimates that it will need to acquire an additional 5 MegaWatt capacity for an entire period of one year starting next month.
This LSE has no plan to build additional generators and decides to purchase capacity from NYISO spot auction to meet the requirement. Since the LSE has exposure in the NYISO Auction spot market, they decide to hedge their price exposure using a futures contract that financially settles on the spot auction price.
The NYISO NYC In-City Capacity Calendar-Month futures, contract code NNC, can be used to hedge this exposure.
The LSE buys a strip of monthly NNC futures, starting from the spot month contract on the futures curve with an average price of $5 per kilowatt month.
In the meantime, it participates in the spot month auction for the next 12 months to procure capacity in the physical market to meet NYSIO capacity requirement.
At the end of the 12-month period, this firms spent an average of $7 per kilowatt month to buy capacity from the spot auction market. Since its long position in the strip of financial futures settles on the spot auction price, it gained a $2 per kilowatt month profit from the financial position.
Overall, this firm saved $2 per kilowatt month or approximately $120,000 by buying capacity futures to lock in its spot auction price exposure.