Capacity commitment and price volatility in a competitive electricity market

The long lead time required to add new capacity in the electricity generation industry means that daily demands are necessarily served by capacity already installed. However, in a competitive market, even if the installed capacity was designed to serve the projected demands, frequent surpluses and occasional full utilization inevitably lead to price volatility. This paper develops a two-stage model of the generation market in which capacity construction occurs in stage 1, before demand realization, and price determination occurs in stage 2, when the equilibrium price ensures that the realized demand does not exceed the installed capacity. We show that price volatility and price spikes are inevitable, and that while price capping can mitigate high and volatile prices, it causes unmet demands and reduction in system reliability. This paper accentuates the interdependence among generating capacity, price volatility and service reliability, a primary cause of concern in the debate on electricity market reform.