Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2016/5: Precautionary Storage in Electricity Markets

Tunç Durmaz ()
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Tunç Durmaz: School of Energy and Environment, City University of Hong Kong, Postal: G5702, 5/F, Academic 1, City University of Hong Kong , Tat Chee Avenue, Kowloon, Hong Kong

Abstract: As renewable energy depends on meteorological shocks and is non-controllable, the overall energy production becomes riskier with the rising renewable share. Although this has led to a renewed interest in storage technologies, not much consideration has been given to energy storage due to precautionary motives. In our study, we look at to what extent a convex marginal utility (prudence) and a convex marginal cost (frugality) can spur precautionary energy storage. We set up a simple theoretical model of energy consumption and production with intermittent renewable sources, dispatchable systems, and energy storage. First, we characterize the optimum and demonstrate how prudence and frugality can lead to higher levels of energy storage. By applying our findings to perfectly competitive markets, we further show that prudence and frugality increase the market energy price through higher demand for energy storage and decrease price volatility. Our analysis can have implications for inventory decisions in various other industries where firms face capacity constraints and are exposed to production risks.

Keywords: Precautionary energy storage; Intermittency; Renewable energy; Fossil fuel energy; Prudence; Frugality; Rational Expectations Equilibrium

JEL-codes: D24; D41; D81; D84; Q41; Q42

29 pages, February 25, 2016

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