Paid to produce absolutely nothing? A Nash-Cournot analysis of a proposed power purchase agreement

We investigate the incentive, market-behavior, and welfare effects of a proposed profit guarantee and associated power purchase agreement (PPA), which was introduced to ensure that generating firms remain viable through periods of higher-than-normal costs. The PPA ensures a guaranteed profit level either by transferring excess revenues from the affected firms to consumers or levying a surcharge on consumers to fund a subsidy for the affected firms. We develop and analyze a stylized Nash-Cournot model of a wholesale electricity market to examine the incentive effects of the proposed PPA. We find that the proposed PPA has incentive impacts that are contrary to its stated aim. The PPA incentivizes uneconomic firms to remain in the market when otherwise they would exit and incentivizes the shutdown of otherwise economically viable firms to restrict output, increasing prices. We find that the effects are pronounced by the corporate-separation asset-ownership structure that is employed in many jurisdictions. The theoretical results of the Nash-Cournot analysis are illustrated with a numerical case study which shows the deleterious consumer- and social-welfare effects of this incentive scheme. We discuss practical implications for regulatory policy, namely, that the proposed mechanism is ill-conceived, inefficient, and creates perverse incentives.