2020

Optimal Capacity Mechanisms for Competitive Electricity Markets

Reprint No. 2020:83

Author(s): Pär Holmberg and Robert A. RitzYear: 2020 Title: Energy Journal Volume (No.): 41 (SI1) Pages: 33–66
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Preliminary version


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.


Reference:
Holmberg, Pär and Robert A. Ritz (2020), "Optimal Capacity Mechanisms for Competitive Electricity Markets". Energy Journal 41(SI1), 33–66.

Pär Holmberg

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