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The inevitability of capacity underinvestment in competitive electricity markets

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  • Milstein, Irena
  • Tishler, Asher
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    Abstract

    Very tight generation capacity (‘underinvestment’) in competitive electricity markets is a major concern to policymakers. Employing a model with endogenous capacity, capacity mix, operations and with uncertain demand we show that ‘underinvestment’ is due to the rational (non-abusive) behavior of profit-seeking producers and other market participants. Instead of building new capacity that will be idle during most of the year, electricity producers let the electricity price spike (price spikes ‘substitute’ for capacity). These results hold true when each electricity producer is allowed to construct and operate only one (base or peaking) generation technology or both, although capacity mix, industry profits and consumer surplus may differ substantially between these two market structures. We also show, for both market structures, how CO2 taxes affect consumer surplus and the industry's optimal capacity, capacity mix and profits, and demonstrate that total welfare gains from the CO2 tax may be substantial. Finally, we provide the regulator with easy-to-use tools to decide which market structure is to be preferred in terms of social welfare.

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    File URL: http://www.sciencedirect.com/science/article/pii/S0140988311001344
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    Bibliographic Info

    Article provided by Elsevier in its journal Energy Economics.

    Volume (Year): 34 (2012)
    Issue (Month): 1 ()
    Pages: 62-77

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    Handle: RePEc:eee:eneeco:v:34:y:2012:i:1:p:62-77

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    Web page: http://www.elsevier.com/locate/eneco

    Related research

    Keywords: Electricity markets; Endogenous capacity; Capacity underinvestment; Optimal capacity mix; Price spikes; Market structure;

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    References

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    Cited by:
    1. Milstein, Irena & Tishler, Asher, 2011. "Intermittently renewable energy, optimal capacity mix and prices in a deregulated electricity market," Energy Policy, Elsevier, vol. 39(7), pages 3922-3927, July.
    2. Woo, C.K. & Li, R. & Shiu, A. & Horowitz, I., 2013. "Residential winter kWh responsiveness under optional time-varying pricing in British Columbia," Applied Energy, Elsevier, vol. 108(C), pages 288-297.
    3. Andreas Schröder & Maximilian Bracke, 2012. "Integrated Electricity Generation Expansion and Transmission Capacity Planning: An Application to the Central European Region," Discussion Papers of DIW Berlin 1250, DIW Berlin, German Institute for Economic Research.

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