The inevitability of capacity underinvestment in competitive electricity markets

Irena Milstein and Asher Tishler

Energy Economics, 2012, vol. 34, issue 1, 62-77

Abstract: Very tight generation capacity (‘underinvestment’) in competitive electricity markets is a major concern to policymakers. Employing a model with endogenous capacity, capacity mix, operations and with uncertain demand we show that ‘underinvestment’ is due to the rational (non-abusive) behavior of profit-seeking producers and other market participants. Instead of building new capacity that will be idle during most of the year, electricity producers let the electricity price spike (price spikes ‘substitute’ for capacity). These results hold true when each electricity producer is allowed to construct and operate only one (base or peaking) generation technology or both, although capacity mix, industry profits and consumer surplus may differ substantially between these two market structures. We also show, for both market structures, how CO2 taxes affect consumer surplus and the industry's optimal capacity, capacity mix and profits, and demonstrate that total welfare gains from the CO2 tax may be substantial. Finally, we provide the regulator with easy-to-use tools to decide which market structure is to be preferred in terms of social welfare.

Keywords: Electricity markets; Endogenous capacity; Capacity underinvestment; Optimal capacity mix; Price spikes; Market structure (search for similar items in EconPapers)
JEL-codes: D24 D43 L11 L94 (search for similar items in EconPapers)
Date: 2012
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (28)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0140988311001344
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:eneeco:v:34:y:2012:i:1:p:62-77

DOI: 10.1016/j.eneco.2011.07.004

Access Statistics for this article

Energy Economics is currently edited by R. S. J. Tol, Beng Ang, Lance Bachmeier, Perry Sadorsky, Ugur Soytas and J. P. Weyant

More articles in Energy Economics from Elsevier
Bibliographic data for series maintained by Catherine Liu ().