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The Visible Hand: Ensuring Optimal Investment in Electric Power Generation

  • Léautier, Thomas-Olivier

This article formally analyzes the causes of underinvestment in electric power generation, and the various corrective market designs that have been proposed and implemented. It yields four main analytical findings. First, using a simple numerical example, (a linear demand function, calibrated on the French power load duration curve), strategic supply reduction is shown to be a more important cause of underinvestment than the imposition of a price cap. Second, physical capacity certificates markets implemented in the United States restore optimal investment, but increase producers' profits beyond the imperfect competition level. Third, financial reliability options, proposed in many markets, fail to restore investment incentives. If a "no short sale" condition is added, they are equivalent to physical capacity certificates. Finally, if competition is perfect, energy only markets yield a negligible underinvestment compared to the optimum. Taken together, these findings suggest that, to ensure generation adequacy, policy makers should put more effort on enforcing competitive behavior in the energy markets, and less on designing additional markets.

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Paper provided by Toulouse School of Economics (TSE) in its series TSE Working Papers with number 10-153.

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Date of creation: Sep 2011
Date of revision: 19 Aug 2012
Publication status: Published in The Energy Journal, 2015.
Handle: RePEc:tse:wpaper:22641
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  1. Lijesen, Mark G., 2007. "The real-time price elasticity of electricity," Energy Economics, Elsevier, vol. 29(2), pages 249-258, March.
  2. Paul L. Joskow & Jean Tirole, 2004. "Reliability and Competitive Electricity Markets," NBER Working Papers 10472, National Bureau of Economic Research, Inc.
  3. Léautier, Thomas-Olivier, 2012. "Is mandating "smart meters" smart?," TSE Working Papers 12-341, Toulouse School of Economics (TSE).
  4. Anette Boom, 2007. "Vertically Integrated Firms' Investments in Electricity Generating Capacities," CIE Discussion Papers 2007-14, University of Copenhagen. Department of Economics. Centre for Industrial Economics.
  5. 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.
  6. Natalia Fabra & Nils‐Henrik M von der Fehr & María‐Ángeles de Frutos, 2011. "Market Design and Investment Incentives," Economic Journal, Royal Economic Society, vol. 121(557), pages 1340-1360, December.
  7. Severin Borenstein & Stephen P. Holland, 2003. "On the Efficiency of Competitive Electricity Markets With Time-Invariant Retail Prices," NBER Working Papers 9922, National Bureau of Economic Research, Inc.
  8. 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.
  9. 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.
  10. Severin Borenstein, 2005. "The Long-Run Efficiency of Real-Time Electricity Pricing," The Energy Journal, International Association for Energy Economics, vol. 0(Number 3), pages 93-116.
  11. Finon, Dominique & Pignon, Virginie, 2008. "Capacity mechanisms in imperfect electricity markets," Utilities Policy, Elsevier, vol. 16(3), pages 141-142, September.
  12. D. Finon & V. Pignon, 2008. "Capacity mechanisms in imperfect electricity markets," Post-Print hal-00716763, HAL.
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