Getting the formation of prices in wholesale electricity markets right is key to ensuring reliability, delivering value for money, and empowering and protecting consumers. Yet many of the measures proposed to address what is known as the “missing money problem” instead create a new problem: misallocated money, overcompensating some resources and undercompensating others. The consequences of this misallocation put the business case for low-carbon power system innovation at risk, a particular concern at this time of transformation in the sector. This paper offers a brief refresher on how we should expect energy prices to form in a modern system, the ways in which they should be expected to shape critical investment decisions, and some of the ways energy price formation can go wrong. With this as a foundation, author Michael Hogan lays out a robust and sustainable approach to ensuring a reliable, low-carbon electric supply at the lowest reasonable cost.

The causes of “missing money” include failing to properly value the demand for balancing requirements, administrative measures (such as price caps) intended to rein in market power, and beneficial public policy measures whose design does not account for any price distortion effects. To tackle the problem effectively, regulators have three options. Top priority should be given to redressing the root causes of the missing money directly. Because this will take time, however, policymakers can reinforce their efforts by adopting administrative mechanisms that add missing money back into energy and balancing services markets. These two strategies, deployed in tandem, offer the best chance to ensure reliability at least cost. A capacity remuneration mechanism, which compensates investors in capacity resources outside the energy and balancing markets, is a third-best option. If resorted to, it should be designed as much as possible to recognize the higher relative value of more flexible resources; it should be accompanied by a thorough reform of the process for assessing the amount of capacity really needed to ‘keep the lights on’ in accordance with the established standard; and it should be a supplement to, rather than a substitute for, measures to improve the quality of energy price formation, with the ultimate objective that at some point in the future it will no longer be needed.