A Primer on Capacity Mechanisms
32 Pages Posted: 6 Aug 2018
Date Written: July 2018
I build a simple model to capture the key drivers of investment and pricing incentives in electricity markets. The focus is put on the interaction between market power and investment incentives, and the trade-off it introduces when designing the optimal regulatory instruments. In contrast to the energy-only market paradigm that assumes perfect competition, my model demonstrates that in the presence of market power scarcity prices do not promote efficient investments, even among risk-neutral investors. Combining price caps and capacity payments allows to disentangle the two-fold objective of inducing the right investment incentives while mitigating market power. Bundling capacity payments with financial obligations further mitigate market power as long as strike prices are set sufficiently close to marginal costs.
Keywords: capacity markets, market power, reliability options, scarcity pricing
JEL Classification: L13, L51, L94
Suggested Citation: Suggested Citation