Optimal Capacity Mechanisms for Competitive Electricity Markets

Pär Holmberg and Robert Ritz

The Energy Journal, 2020, vol. 41, issue 1_suppl, 33-66

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.

Keywords: Investment; Wholesale electricity market; Capacity mechanism; Capacity auction; Strategic reserve (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (1)

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Journal Article: Optimal Capacity Mechanisms for Competitive Electricity Markets (2021)
Journal Article: Optimal Capacity Mechanisms for Competitive Electricity Markets (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:sae:enejou:v:41:y:2020:i:1_suppl:p:33-66

DOI: 10.5547/01956574.41.SI1.phol

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