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Energy Journal

Optimal Capacity Mechanisms for Competitive Electricity Markets

Scientific Article in English
Holmberg, Pär and Robert A. Ritz (2020). “Optimal Capacity Mechanisms for Competitive Electricity Markets”. Energy Journal 41, 33–66.

Pär Holmberg, Robert A. Ritz

Capacity mechanisms are increasingly used in electricity market design around the world yet their role remains hotly debated. This paper introduces a new benchmark model of a capacity mechanism in a competitive electricity market with many different conventional 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. Our analysis yields 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, (i) we show how increasing variable renewables penetration can enhance the need for a capacity payment under a novel condition called “imperfect system substitutability” , and (ii) we outline the socially-optimal design of a strategic reserve with a targeted capacity payment.

Pär Holmberg

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