The Visible Hand: Ensuring Optimal Investment in Electric Power Generation

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.