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.

An insurance mechanism for electricity reliability differentiation under deep decarbonization

“…For some strategic reserve designs, decisions on the quantities of reserve procured can be relatively ad-hoc and subject to high-level capacity or budgetary limits [7]. The most common approach to the procurement of strategic reserves involves quantifying the amount of additional generation required to meet a centrally determined reliability metric, such as unserved energy (USE) or loss of load probability (LOLP) [10,[12][13][14]. In the context of variable generation an expected value of the metric (e.g.…”