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The impact of electricity market design upon investment under uncertainty: The effectiveness of capacity mechanisms

  • de Vries, Laurens
  • Heijnen, Petra
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    This paper presents an analysis of different market designs under uncertainty about the future growth rate of demand. Markets for electricity generation appear to be prone to an investment cycle due to their capital-intensiveness and the long lead time of new generation facilities. We tested the stability of different capacity mechanisms in the presence of uncertainty regarding the demand growth rate with a stochastic dynamic model. Investment decisions were assumed to maximize profit, based on an assumed growth rate of demand that was equal to the rolling average of the previous five years. All capacity mechanisms proved effective in reducing the tendency towards an investment cycle, but to different degrees. Interestingly, an oligopoly that is able to raise average prices by 10% would also be able to substantially reduce price volatility and decrease the risk of shortages by increasing the reserve margin. Benefits of such a strategy for the generating companies could be that it would deter new market entrants and stave off the political attention that shortages and price spikes would bring about. However, the benefits to consumers are compromised by the lack of economic efficiency and distributional effects of an oligopoly, while the stability of such an oligopolistic strategy can be questioned. The most attractive solution is a system of reliability contracts, which can be used to stabilize both investment and prices, while reducing market power and providing more efficient operational incentives to generating companies.

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    File URL: http://www.sciencedirect.com/science/article/B6VFT-4RWHGS5-1/1/c5ab1df1ba017a05d316568c6ee417d5
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    Article provided by Elsevier in its journal Utilities Policy.

    Volume (Year): 16 (2008)
    Issue (Month): 3 (September)
    Pages: 215-227

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    Handle: RePEc:eee:juipol:v:16:y:2008:i:3:p:215-227
    Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30478

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    1. Joskow, Paul L., 2008. "Capacity payments in imperfect electricity markets: Need and design," Utilities Policy, Elsevier, vol. 16(3), pages 159-170, September.
    2. Neuhoff, K., 2004. "Large Scale Deployment of Renewables for Electricity Generation," Cambridge Working Papers in Economics 0460, Faculty of Economics, University of Cambridge.
    3. De Vries, Laurens J., 2007. "Generation adequacy: Helping the market do its job," Utilities Policy, Elsevier, vol. 15(1), pages 20-35, March.
    4. Neuhoff, K. & de Vries, L., 2004. "'Insufficient Incentives for Investment in Electricity Generation’," Cambridge Working Papers in Economics 0428, Faculty of Economics, University of Cambridge.
    5. Joskow, Paul L & Tirole, Jean, 2007. "Reliability and Competitive Electricity Markets," CEPR Discussion Papers 6121, C.E.P.R. Discussion Papers.
    6. Peter Cramton & Steven Stoft, 2008. "Forward Reliability Markets: Less Risk, Less Market Power, More Efficiency," Papers of Peter Cramton 08frm, University of Maryland, Department of Economics - Peter Cramton, revised 2008.
    7. Frank A. Wolak & Robert H. Patrick, 2001. "The Impact of Market Rules and Market Structure on the Price Determination Process in the England and Wales Electricity Market," NBER Working Papers 8248, National Bureau of Economic Research, Inc.
    8. Batlle, Carlos & Pérez-Arriaga, Ignacio J., 2008. "Design criteria for implementing a capacity mechanism in deregulated electricity markets," Utilities Policy, Elsevier, vol. 16(3), pages 184-193, September.
    9. Nils-Henrik von der Fehr & David Harbord, 2002. "Competition in Electricity Spot Markets: Economic Theory and International Experience," Industrial Organization 0203006, EconWPA.
    10. Finon, Dominique & Pignon, Virginie, 2008. "Electricity and long-term capacity adequacy: The quest for regulatory mechanism compatible with electricity market," Utilities Policy, Elsevier, vol. 16(3), pages 143-158, September.
    11. Ford, Andrew, 2001. "Waiting for the boom: : a simulation study of power plant construction in California," Energy Policy, Elsevier, vol. 29(11), pages 847-869, September.
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