Capacity Mechanisms and the Technology Mix in Competitive Electricity Markets

32 Pages Posted: 3 Aug 2020

See all articles by Par Holmberg

Par Holmberg

Research Institute of Industrial Economics (IFN)

Robert A. Ritz

University of Cambridge - Judge Business School

Date Written: June 29, 2019

Abstract

Capacity mechanisms are increasingly used in electricity market design around the world yet their role remains hotly debated. In this paper, we introduce a new benchmark model of a capacity mechanism in a competitive electricity market with many different generation technologies. We consider two policy instruments, a wholesale price cap and a capacity payment, and show which combinations of these instruments induce socially-optimal investment by the market. Changing the price cap or capacity payment affects investment only in peak generation plant, with no equilibrium impact on baseload or mid-merit plant. We obtain a rationale for a capacity mechanism based on the internalization of a system-cost externality even where the price cap is set at the value of lost load. In extensions, we show how increasing renewables penetration enhances the need for a capacity mechanism, and outline an optimal design of a strategic reserve with a discriminatory capacity payment.

Keywords: Investment, wholesale electricity market, capacity mechanism, capacity auction, strategic reserve

JEL Classification: D41, L94

Suggested Citation

Holmberg, Par and Ritz, Robert A., Capacity Mechanisms and the Technology Mix in Competitive Electricity Markets (June 29, 2019). IFN Working Paper No. 1292, 2019, Available at SSRN: https://ssrn.com/abstract=3644253 or http://dx.doi.org/10.2139/ssrn.3644253

Par Holmberg (Contact Author)

Research Institute of Industrial Economics (IFN) ( email )

Box 55665
Grevgatan 34, 2nd floor
Stockholm, SE-102 15
Sweden

Robert A. Ritz

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

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