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Optimal Capacity Mechanisms for Competitive Electricity Markets

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  • Pär Holmberg and Robert A. Ritz

Abstract

Capacity mechanisms are increasingly used in electricity market design around the world yet their role remains hotly debated. This paper introduces a new benchmark model of a capacity mechanism in a competitive electricity market with many different conventional 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. Our analysis yields a rationale for a capacity mechanism based on the internalization of a system-cost externalityýeven where the price cap is set at the value of lost load. In extensions, (i) we show how increasing variable renewables penetration can enhance the need for a capacity payment under a novel condition called "imperfect system substitutability" , and (ii) we outline the socially-optimal design of a strategic reserve with a targeted capacity payment.

Suggested Citation

  • Pär Holmberg and Robert A. Ritz, 2020. "Optimal Capacity Mechanisms for Competitive Electricity Markets," The Energy Journal, International Association for Energy Economics, vol. 0(Special I).
    • Handle: RePEc:aen:journl:ej41-si1-holmberg
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    Cited by:

    1. Astier, Nicolas & Ovaere, Marten, 2022. "Reliability standards and generation adequacy assessments for interconnected electricity systems," Energy Policy, Elsevier, vol. 168(C).
    2. Billimoria, Farhad & Fele, Filiberto & Savelli, Iacopo & Morstyn, Thomas & McCulloch, Malcolm, 2022. "An insurance mechanism for electricity reliability differentiation under deep decarbonization," Applied Energy, Elsevier, vol. 321(C).
    3. Lukas Block & Bastian Westbrock, 2022. "Capacity investments in a competitive energy market," Working Papers Dissertations 95, Paderborn University, Faculty of Business Administration and Economics.
    4. Peter Cramton & Emmanuele Bobbio & David Malec & Pat Sujarittanonta, 2022. "Electricity Markets in Transition: A Multi-Decade Micro-Model of Entry and Exit in Advanced Wholesale Markets," ECONtribute Discussion Papers Series 183, University of Bonn and University of Cologne, Germany.
    5. Sirin, Selahattin Murat & Camadan, Ercument & Erten, Ibrahim Etem & Zhang, Alex Hongliang, 2023. "Market failure or politics? Understanding the motives behind regulatory actions to address surging electricity prices," Energy Policy, Elsevier, vol. 180(C).
    6. Bichuch, Maxim & Hobbs, Benjamin F. & Song, Xinyue, 2023. "Identifying optimal capacity expansion and differentiated capacity payments under risk aversion and market power: A financial Stackelberg game approach," Energy Economics, Elsevier, vol. 120(C).

    More about this item

    JEL classification:

    • F0 - International Economics - - General

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