Financing Long-Term Generation Capacity in a Reference Price Oriented Capacity Market

Abstract

Many power markets around the world have been facing inadequacy with generation capacity investment to meet the growing demand. Among various frameworks directed towards this problem, capacity markets have emerged in major eastern US power markets. In this paper, a prototype capacity market is discussed which is consistent with the trend of convergence of market design. Based on this, the critical role of the reference capacity price is brought up, followed by a detailed explanation of its economic rationale and concerns. Noted with the necessity of a systematic pricing scheme to determine the value of the reference capacity price, a pricing model based on the general Black-Scholes contingent claim framework is proposed. In this model, the capacity value is treated as a path-dependent derivative with electricity prices and natural gas prices as underlyings. Numerical study is conducted to prove model validity with a lattice approach adopted.