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Capacity payments in imperfect electricity markets: Need and design

  • Joskow, Paul L.

This paper argues that a variety of imperfections in wholesale "energy-only" electricity markets lead to generators earning net revenues that are inadequate to support investment in a least cost portfolio of generating capacity and to satisfy consumer preferences for reliability. Theoretical and numerical examples are used to illustrate the sources of this "missing money" problem. Improvements in "energy-only" wholesale electricity markets, especially those that improve pricing when capacity is fully utilized, can reduce the magnitude of the missing money problem. However, these improvements are unlikely to fully ameliorate it. Forward capacity obligations and associated auction mechanisms to determine capacity prices are necessary to restore appropriate wholesale market prices and associated investment incentives to support the optimal portfolio of generating investments. The deficiencies of the original capacity payment mechanisms adopted in the US are discussed and the necessary improvements identified.

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Article provided by Elsevier in its journal Utilities Policy.

Volume (Year): 16 (2008)
Issue (Month): 3 (September)
Pages: 159-170

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Handle: RePEc:eee:juipol:v:16:y:2008:i:3:p:159-170
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30478

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  1. Michael A. Crew & Paul R. Kleindorfer, 1976. "Peak Load Pricing with a Diverse Technology," Bell Journal of Economics, The RAND Corporation, vol. 7(1), pages 207-231, Spring.
  2. Joskow, Paul & Tirole, Jean, 2004. "Retail Electricity Competition," IDEI Working Papers 311, Institut d'Économie Industrielle (IDEI), Toulouse.
  3. Peter Cramton & Steven Stoft, 2006. "The Convergence of Market Designs for Adequate Generating Capacity," Papers of Peter Cramton 06mdfra, University of Maryland, Department of Economics - Peter Cramton, revised 2006.
  4. Joskow, P. & Tirole, J., 2004. "Reliability and Competitive Electricity Markets," Cambridge Working Papers in Economics 0450, Faculty of Economics, University of Cambridge.
  5. Green, R., 2004. "Electricity Transmission Pricing: How much does it cost to get it wrong?," Cambridge Working Papers in Economics 0466, Faculty of Economics, University of Cambridge.
  6. Richard Gilbert & Karsten Neuhoff & David Newbery, 2004. "Allocating Transmission to Mitigate Market Power in Electricity Markets," RAND Journal of Economics, The RAND Corporation, vol. 35(4), pages 691-709, Winter.
  7. Chao, Hung-po & Wilson, Robert, 1987. "Priority Service: Pricing, Investment, and Market Organization," American Economic Review, American Economic Association, vol. 77(5), pages 899-916, December.
  8. Paul L. Joskow, 1976. "Contributions to the Theory of Marginal Cost Pricing," Bell Journal of Economics, The RAND Corporation, vol. 7(1), pages 197-206, Spring.
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