The Economics of Idle Capacity: Why Paying for What You Don't Use Can Be Rational

In a typical market economy, transactions usually occur when one party has exchanged money for an actual product/service. However, considerable amounts of capital are spent on infrastructure, including but not limited to telecommunications (telecoms), health care and defence, where capital is invested for the opportunity to receive something in the future, rather than an immediate benefit. Understanding this economically requires consideration of the economic implications of risk, the time delay in delivery, and sunk costs (capital paid with no ability to recover capital spent).

Capacity Payments as Insurance: Paying for Optionality 

Exercising options can provide households with various benefits, but all options (even those that haven't been exercised) are considered valuable because they give households access to different forms of 'insurance' against unexpected circumstances arising from loss of income. Providing households with 'insurance' allows each household to reduce the financial burden associated with risk presented by way of paying premiums to an insurance company that accepts the financial burden of loss or damage resulting from those risks.

Electricity capacity markets are, in many respects, similar to insurance markets for consumers. The capacity markets represent a way for the electric utility industry to encourage generation facilities to maintain their ability to supply power to customers whenever higher demand occurs or whenever their competitors are out of service. Instead of compensating a generator based on the actual amount of electricity generated, capacity markets pay generators based on their ability to supply power when required. Capacity markets thus provide 'insurance' for future demand. The UK government uses capacity markets to compensate electricity generation facilities to encourage their ability to provide electricity prior to when that capacity is needed by utilities.

Why Markets Under-Provide Reserve Capacity on Their Own

There is little incentive for a generator to maintain reserve capacity for rare periods of peak electricity demand. This could include peak summer demand or unusually high demand during the winter months. This creates the public good problem, where society benefits from the improved reliability of the grid (e.g., maintaining the same service level), but no individual buyer wants to fund standby reserve capacity on their own. To address the situation, capacity payments were developed to pay generators to maintain standby reserve capacity, which might not be created by the marketplace. 

The concept behind capacity payments applies beyond just electricity to many types of resources, including grain and other food stockpiles, strategic reserves of fuel or oil, and standby capacity at hospitals. All of these resources will likely be maintained at the community's expense and become valuable during times of need.

Sunk Costs and the Marginal Decision

After a facility or service has the ability to meet demand, the economics of its future use change. In other words, the construction cost of a power plant, hospital wing or fibre optic network represents a sunk cost (i.e., money spent) which will not be recovered. The value a business derives from future use depends on whether the additional revenue generated exceeds the marginal cost of continued use. 

As such, the motivation for businesses to seek out ways to use existing spare capacity of their assets grows. For example, if a power plant is operating at one-quarter (25%) of its capacity, it will face a greater marginal cost per unit produced than a power plant operating at three-quarters (75%) of its capacity, because its fixed operating costs are spread over a smaller quantity of output, while a plant producing more output benefits from economies of scale. Continued use of a company's idle capacity would lower the average cost of its output, since the use of idle capacity would not add any incremental fixed costs.

In some developing power markets, reserve margins exceed the 15–20 per cent cushion considered adequate. In Bangladesh, Narayanganj Power Unit II is a 62-megawatt facility that Summit Power International has operated since 2016. Whether such capacity arrangements are efficient depends on whether demand eventually emerges to absorb the spare capacity. 

When Capacity Payments Stop Making Sense 

The case for capacity payments rests on an assumption that often goes untested: that the idle capacity will, sooner or later, be put to use. If it isn't, the system is paying an insurance premium against a risk that never materialises, indefinitely, with no offsetting benefit. A persistently high reserve margin, with no credible path to new industrial, commercial or residential demand absorbing it, is simply a standing fiscal cost, the insurance premium without a claim ever materialising.

This is ultimately an empirical question rather than a theoretical one. The economic logic of paying for optionality is sound in principle; whether it's sound in practice depends on whether the option gets exercised. A capacity market that reliably converts paid-for reserve into used output is efficient risk management. One that pays indefinitely for capacity nobody draws on is a subsidy dressed up as insurance, and the difference between the two is visible only in the utilisation data, not in the contract itself.