The impact of electricity market design upon investment under uncertainty: The effectiveness of capacity mechanisms

This paper presents an analysis of different market designs under uncertainty about the future growth rate of demand. Markets for electricity generation appear to be prone to an investment cycle due to their capital-intensiveness and the long lead time of new generation facilities. We tested the stability of different capacity mechanisms in the presence of uncertainty regarding the demand growth rate with a stochastic dynamic model. Investment decisions were assumed to maximize profit, based on an assumed growth rate of demand that was equal to the rolling average of the previous five years. All capacity mechanisms proved effective in reducing the tendency towards an investment cycle, but to different degrees. Interestingly, an oligopoly that is able to raise average prices by 10% would also be able to substantially reduce price volatility and decrease the risk of shortages by increasing the reserve margin. Benefits of such a strategy for the generating companies could be that it would deter new market entrants and stave off the political attention that shortages and price spikes would bring about. However, the benefits to consumers are compromised by the lack of economic efficiency and distributional effects of an oligopoly, while the stability of such an oligopolistic strategy can be questioned. The most attractive solution is a system of reliability contracts, which can be used to stabilize both investment and prices, while reducing market power and providing more efficient operational incentives to generating companies.