Scandinavian Working Papers in Economics
Working Paper Series,
Research Institute of Industrial Economics
No 1292: Capacity Mechanisms and the Technology Mix in Competitive Electricity Markets
Pär Holmberg () and Robert A. Ritz ()
Additional contact information
Pär Holmberg: Research Institute of Industrial Economics (IFN), Postal: Stockholm, Sweden, Policy Research Group (EPRG), University of Cambridge, and Program on Energy and Sustainable Development (PESD), Stanford University
Robert A. Ritz: Energy Policy Research Group (EPRG), Judge Business School, University of Cambridge
Abstract: Capacity mechanisms are increasingly used in electricity market design around the world yet their role remains hotly debated. In this paper, we introduce a new benchmark model of a capacity mechanism in a competitive electricity market with many different generation technologies. We consider two policy instruments, a wholesale price cap and a capacity payment, and show which combinations of these instruments induce socially-optimal investment by the market. Changing the price cap or capacity payment affects investment only in peak generation plant, with no equilibrium impact on baseload or mid-merit plant. We obtain a rationale for a capacity mechanism based on the internalization of a system-cost externality – even where the price cap is set at the value of lost load. In extensions, we show how increasing renewables penetration enhances the need for a capacity mechanism, and outline an optimal design of a strategic reserve with a discriminatory capacity payment.
Keywords: Investment; Wholesale electricity market; Capacity mechanism; Capacity auction; Strategic reserve
31 pages, July 1, 2019
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