Investment Dynamics in Electricity Markets

Abstract:     
We investigate the incentives for capacity investments in a simple strategic dynamic model with random demand growth. We construct non-collusive Markovian equilibria where the firms' decisions depend on the current capacity stock only. The firms maintain small reserve margins and high market prices, and extract large rents. In some equilibria, rationing occurs with positive probability, so the market mechanism does not ensure 'security of supply'. The price cap reflects the value of lost energy or lost load (VOLL) that consumers place on severily reducing consumption on short notice. Our welfare analysis suggests that a lower value for the price cap would reduce market prices and increase consumer surplus, without affecting the level of investment.

Keywords: electricity markets, Markov perfect equilibrium, auctions

JEL Classifications: D43, D44, C73

Working Paper Series