Capacity choice and water management in hydroelectricity systems

This paper proposes a simple two-period model that captures the seasonal pattern of water inflows and electricity demand observed in many countries where hydropower is a major source of electricity supply. The model characterizes the effects of different inflows pattern on the optimal water management, capacity, and the associated electricity production and price. The first best capacity is a non-monotonic function of water inflows, which provides a rationale for the observed differences in reservoirs sizes across hydropower systems around the world. The monopoly solution is qualitatively similar to the first best outcome, and the privatization of hydroelectric power generation systems does not always imply a social welfare loss.