Investment dynamics in electricity markets

Alfredo Garcia, Ennio Stacchetti

    Research output: Contribution to journalArticle

    Abstract

    We investigate the incentives for investments in capacity in a simple strategic dynamic model with random demand growth. We construct non-collusive Markovian equilibria where the firms' decisions depend on the current capacity stock only. The firms maintain small reserve margins and high market prices, and extract large rents. In some equilibria, rationing occurs with positive probability, so the market mechanism does not ensure 'security of supply'. Usually, the price cap reflects the value of lost energy or lost load (VOLL) that consumers place on severely reducing consumption on short notice. Our analysis identifies a minimum price cap, unrelated to the VOLL, that allows the firms to recoup their investment and production costs in equilibrium. However, raising the price cap above this minimum increases market prices and reduces consumer surplus, without affecting the level of investment.

    Original languageEnglish (US)
    Pages (from-to)149-187
    Number of pages39
    JournalEconomic Theory
    Volume46
    Issue number2
    DOIs
    StatePublished - 2011

    Keywords

    • Dynamic investment game
    • Electricity markets
    • Markov perfect equilibrium
    • Uniform price auction

    ASJC Scopus subject areas

    • Economics and Econometrics

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