Thermal Capacity as Reliability Insurance: Welfare Redistribution in Electricity Market

Why do electricity systems maintain costly thermal capacity that appears difficult to justify under standard market criteria, and what are the welfare consequences of doing so? We address this question by interpreting thermal backup capacity as a form of reliability insurance against high-impact, low-probability scarcity events. Building on the model of Joskow and Tirole (2007), we incorporate social risk aversion into the capacity-planning problem, allowing investment decisions to reflect not only expected welfare losses but also society’s concern about extreme scarcity events. Using detailed data from the Uruguayan electricity system, we estimate the degree of social risk aversion implicit in observed capacity choices and evaluate the resulting welfare distribution across consumers with different sensitivities to real-time prices. We find that a risk-neutral framework can explain most generation capacity but fails to account for more than 60% of the system’s fossil thermal capacity. The observed capacity plan is instead consistent with a planning criterion that places substantial weight on welfare losses associated with extreme scarcity events. Additional thermal capacity increases welfare for both consumer groups. Price-insensitive consumers benefit primarily through reduced exposure to electricity shortages, while price-sensitive consumers benefit through lower expected electricity costs and reduced reliance on self-generation. However, the costs and benefits of this reliability insurance are unevenly distributed. Although the welfare gain for price-insensitive consumers is substantially larger, they finance most of the additional investment through higher electricity prices, generating significant welfare transfers toward price-sensitive consumers.