The (In)Ability of LMP to Send True Price Signals for Generation Investment
Posted: 10 May 2009
Date Written: April 8, 2009
Most energy economists believe that locational marginal pricing, or LMP, offers an optimal signal for generation expansion. This belief is based upon inappropriate application of marginal analysis to lumpy generation investment. Because LMP signals are marginal, they cannot signal provide an accurate signal as to how much generation capacity is needed. And because LMPs are calculated incrementally, in the extreme case of a jump discontinuity, LMPs may actually send a false positive signal of the need for new investment. This paper demonstrates by counterexample that LMP need not provide socially optimal signals for generation investment, calling into question one of the foundational arguments for LMP.
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