The inevitability of capacity underinvestment in competitive electricity markets

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.