Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/210933 
Year of Publication: 
2019
Series/Report no.: 
IFN Working Paper No. 1292
Publisher: 
Research Institute of Industrial Economics (IFN), Stockholm
Abstract: 
Capacity mechanisms are increasingly used in electricity market design around the world yet their role remains hotly debated. In this paper, we introduce a new benchmark model of a capacity mechanism in a competitive electricity market with many different 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. Changing the price cap or capacity payment affects investment only in peak generation plant, with no equilibrium impact on baseload or mid-merit plant. We obtain 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, we show how increasing renewables penetration enhances the need for a capacity mechanism, and outline an optimal design of a strategic reserve with a discriminatory capacity payment.
Subjects: 
Investment
Wholesale electricity market
Capacity mechanism
Capacity auction
Strategic reserve
JEL: 
D41
L94
Document Type: 
Working Paper

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