Electricity Investment and Security of Supply in Liberalized Electricity Systems
The European Power Supply Industry, Forthcoming
31 Pages Posted: 17 Apr 2006
Eliciting generation investment by decentralized, profit-seeking private investors is a key goal of electricity liberalization. Debate rages regarding the ability of energy-only electricity markets to ensure that such investors provide generation investment as and when needed to ensure "the lights stay on". Many argue that despite theoretical predictions to the contrary, energy-only markets will under-provide the requisite level of investment, due to market imperfections that are either inherent (such as consumer resistance to real-time pricing) or imposed (such as price caps to curtail market power). The nature of these imperfections is increasingly being debated, with security of supply formerly being regarded as a public good, but later analysis showing this is not the case (or even if it were, why that need not necessitate intervention). Greater attention is now being paid to externalities associated with the provision of security of supply, but evidence on the importance of such externalities is yet to be presented. Similarly lacking is evidence on the superiority of mechanisms often proposed or implemented to encourage investment in generation capacity where energy-only markets are thought to elicit inadequate investment. These mechanisms include capacity payments, capacity obligations, options-based capacity schemes and capacity subscriptions with load-limiting fuses. While the latter are argued to represent an elegant and non-distortionary means to encourage market-based security of supply, the other alternatives are shown to be conditionally optimal at best, and in principle and practice subject to self-defeating features that can be bettered by refinements to energy-only market arrangements (greater demand-side responsiveness) and structural measures (vertical integration of generation and energy retailing). By instead pursuing these alternative measures security of supply is more easily achieved, electricity prices are less vulnerable to exploitation of generator market power, and generation investment is more likely to arise. The need for price caps, which then necessitate compensatory capacity mechanisms to elicit investment, is then reduced. At the same time exposure to regulatory risk is lessened. Combining these measures with greater political and regulatory restraint is argued to provide a more stable and superior means to elicit the investment needed to provide the socially optimal security of supply, addressing any market imperfections at source rather than introducing new mechanisms at least as much at risk of imperfection. The use of capacity mechanisms is argued to increase the risk that energy-only markets will fail to perform as expected and required, undermining the liberalisation process. As such they raise the prospect that governments and regulators concerned about security of supply will once again find themselves responsible for achieving it, at consumers' and/or taxpayers' expense, but with lesser prospect of success.
Keywords: Electricity Investment, Supply Security, Capacity Mechanisms, Vertical Integration, Price Caps, Market Power, Reguatory Risk, Externalities, Public Goods
JEL Classification: D43, D62, H41, H42, L13, L22, L51, L94
Suggested Citation: Suggested Citation