Long-term assessment of power capacity incentives by modeling generation investment dynamics under irreversibility and uncertainty

Abstract

In actual energy-only markets, the high volatility of power prices affects the expected returns of generators. When dealing with irreversibility under uncertainty, deferring decisions to commit in new power plants, waiting for better information, is therefore a rational approach. Theoretical and empirical evidence suggests that such investment pattern determines the occurrence of construction cycles, which strongly compromise supply security. In order to supplement generators' revenues, several remuneration mechanisms have been devised over past years. Along this line, this work addresses the long-run dynamics of capacity adequacy and market efficiency with both a price-based and a quantity-based capacity remuneration policy. For that purpose, a recentlydeveloped, stochastic simulation model is used as a benchmark. Hence, the optimal postponement of generation investment decisions is integrated into a long-run power market model by formulating the decision-making problem in the framework of Real Options Analysis. Results suggest that policymakers may exchange supply security (effectiveness) for energy prices to be paid by consumers (efficiency) when designing and implementing capacity remuneration mechanisms. By doing so, this article contributes to the ongoing debate regarding the design of incentive policies and efficient power markets by considering the microeconomics of investors' decision-making under irreversibility and uncertainty.

Impact of Plant Utilization on Irreversible Investment Under Uncertainty with Application to Refinery Investment

“…A recent work addresses the long-run dynamics of generation capacity for power plant as an irreversible investment problem under uncertainty using real options analysis [24]. In agreement with this new trend of investment decision-making under irreversibility and uncertainty, the present study is apt for including plant capacity utilization.…”

“…In agreement with this new trend of investment decision-making under irreversibility and uncertainty, the present study is apt for including plant capacity utilization. Nonetheless, the way the capacity mechanism is figured out in this study is quite different from that of [24], where capacity is viewed as an incentive. Thus, capacity was defined to be either price-based capacity or quantitybased remuneration capacity.…”

A Systematic Review of European Electricity Market Design Options

“…Rios-Festner et al [41] studied capacity remuneration mechanisms and their impact on capacity adequacy and market efficiency in the long-run. The assessed mechanisms are a price-based (capacity payment) and a quantity-based (capacity market) capacity remuneration mechanism, which are both inserted in an 'energy-only' market and compared to the case of an 'energy-only' market without these incentives.…”

“…Their results indicate that especially integrating capacity markets to an 'energy-only' market enables firm behaviour of the system in the long term and limits the occurrence of construction cycles. Here, the construction cycles are referred to as the long-term evolution of the power system in terms of subsequent periods of under-and over-investment in generation [41]. Moreover, a capacity market can be seen as preferable to capacity payments in promoting capacity adequacy and increasing the security of the supply.…”

Why the sustainable provision of low-carbon electricity needs hybrid markets

“…15 Additionally, under uncertainty and investment irreversibility, there is an option value in deferring decisions to invest in new plants (e.g. Dixit and Pindyck, 1994;Rios-Festner et al, 2020). 16 A classic private lever to address risks is self-insurance, various forms of which (diversification, size increase, vertical integration between generation and retail) have been used by utilities through reconfiguration (mergers & acquisitions) or internal growing.…”