4.1 Article

Investment dynamics in electricity markets

Journal

ECONOMIC THEORY
Volume 46, Issue 2, Pages 149-187

Publisher

SPRINGER
DOI: 10.1007/s00199-009-0508-3

Keywords

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

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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.

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