Welfare implications of capacity payments in a price-capped electricity sector: A case study of the Texas market (ERCOT)

- We study welfare consequences of introducing capacity payments in the electricity sector.
- We analyze both a perfectly competitive market and a market with dominant firms.
- Capacity payments solve the volatility-reliability tradeoff but increase consumers' electricity bill.
- We evaluate the gains for consumers using data from Texas ERCOT.

The aim of this paper is to analyze the welfare consequences of introducing capacity compensation payments in restructured and liberalized electricity markets. For that purpose, we set up a two-stage framework in which two kinds of electricity generators, peak load and base load generators, choose their capacity investment levels first and then compete on the basis of bids in a centralized market to sell electricity to consumers. We use data from the Texas ERCOT to evaluate consumers' welfare. We find that the introduction of capacity payments has two countervailing effects. On the one hand, it increases the wholesale electricity price. On the other hand, it reduces price volatility and increases the reliability of the system. We find that capacity payments are more beneficial for consumers in a perfectly competitive market than in the presence of certain degree of market power.