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Fuel cost uncertainty, capacity investment and price in a competitive electricity market

Nurit Gal, Irena Milstein, Asher Tishler and Chi-Keung Woo

Energy Economics, 2017, vol. 61, issue C, 233-240

Abstract: This paper studies the effect of natural-gas fuel cost uncertainty on capacity investment and price in a competitive electricity market. Our model has a two-stage decision process. In the first stage, an independent power producer (IPP) builds its optimal capacity, conditional on its perceived uncertainties in fuel cost and electricity demand. In the second stage, equilibrium prices and quantities are determined by IPPs competing in a Cournot market. Under the empirically reasonable assumption that per MWh fuel costs are log-normally distributed, we find that a profit-maximizing IPP increases its capacity in response to rising fuel cost volatility. Consequently, the expected profit of the IPP and expected consumer surplus increase with volatility, rejecting the hypothesis that rising fuel cost uncertainty tends to adversely affect producers and consumers. Expected consumer surplus further increases if the IPP hedges the fuel cost risk. However, the IPP's optimal strategy is not to do so. The policy implication of these results is that the government should not intervene to reduce the price volatility of a well-functioning spot market for natural gas, chiefly because such intervention can have the unintended consequence of discouraging generation investment, raising electricity prices, and harming consumers.

Keywords: Competitive electricity market; Natural gas price volatility; Generation investment under uncertainty; Electricity price (search for similar items in EconPapers)
JEL-codes: D24 D43 L11 L94 L95 (search for similar items in EconPapers)
Date: 2017
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