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Optimal Capacity Mechanisms for Competitive Electricity Markets

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  • Pär Holmberg
  • 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 externality—even 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 & Robert A. Ritz, 2020. "Optimal Capacity Mechanisms for Competitive Electricity Markets," The Energy Journal, , vol. 41(1_suppl), pages 33-66, June.
    • Handle: RePEc:sae:enejou:v:41:y:2020:i:1_suppl:p:33-66
    DOI: 10.5547/01956574.41.SI1.phol
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    Cited by:

    1. Oliver, Matthew E. & Chapman, Oliver & Grijalva, Santiago & Matisoff, Daniel C. & Ramadhani, Maghfira & West, Amanda, 2026. "Managing zero-marginal-cost, intermittent renewable energy: A survey of the engineering, economic, and policy challenges," Renewable and Sustainable Energy Reviews, Elsevier, vol. 226(PC).
    2. Jia, Xinyu & Zou, Hongyang & Xu, Shuxian & Feng, Kuishuang, 2025. "Tolerance vs. Intervention: Strategies for dealing with negative wholesale electricity prices," Energy Policy, Elsevier, vol. 206(C).
    3. Rögnvaldur Hannesson, 2023. "A Simple Conceptual Model of Energy Transition," Biophysical Economics and Resource Quality, Springer, vol. 8(4), pages 1-6, December.
    4. Fleten, Stein-Erik & Fram, Benjamin P. & Ullrich, Carl J., 2024. "The reliability pricing model and coal-fired generators in PJM," Energy Economics, Elsevier, vol. 134(C).

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    • F0 - International Economics - - General

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