Optimal Capacity Mechanisms for Competitive Electricity Markets

Abstract

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.

A Survey of Capacity Mechanisms: Lessons for the Swedish Electricity Market

“…10 Hence, a price cap below * c , the highest variable cost for which investment is efficient, would likely lead to inefficiencies. Holmberg and Ritz (2020) estimate that * c is roughly 50-75% of VOLL p . This rough calculation indicates that the price cap should not be set far below VOLL p if one wants to avoid inefficient investment.…”

“…This reduces the risk of electricity shortages, which reduces the scarcity rent for old plants. In a simplified electricity market, the reduced revenue corresponds exactly to the increase in capacity payments (Holmberg and Ritz, 2020). Hence, in the long run nothing happens to the capacity of existing technologies for a simplified market in equilibrium.…”

“…for the unit with the highest variable cost on the market, which ensures efficient investment incentives (Holmberg and Ritz, 2020).…”

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

“…specific mechanisms (e.g. Abbott, 2001;Joskow and Tirole, 2007;Keppler, 2017;Holmberg and Ritz, 2021).…”

“…3 These externalities are rooted in the involuntary, unexpected, or uncontrolled nature of enforced load-shedding during stress periods. Loss of load therefore entails a system-cost externality or social cost on top of the lost surplus of rationed consumers (Fabra, 2018;Holmberg and Ritz, 2021). 4 There are thus three reasons that provide support to the second view of the underlying causes of the missing money problem.…”