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Faculty of Economics

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Ehrenmann, A. and Smeers, Y.

Stochastic Equilibrium Models for Generation Capacity Expansion

CWPE1041

Abstract: Capacity expansion models in the power sector were among the first applications of operations research to the industry. We introduce stochastic equilibrium versions of these models that we believe provide a relevant context for looking at the current very risky market where the power industry invests and operates. We then look at the insertion of risk related investment practices that developed with the new environment and may not be easy to accommodate in an optimization context. Specifically we consider the use of plant specific discount rates that we derive by including stochastic discount rates in the equilibrium model. Linear discount factors only price systematic risk. We therefore complete the discussion by inserting different risk functions (for different agents) in order to account for additional unpriced idiosyncratic risk in investments. These different models can be cast in a single mathematical representation but they do not have the same mathematical properties. We illustrate the impact of these phenomena on a small but realistic example.

Keywords: Duration models, capacity adequacy, risk functions, stochastic equilibrium models, stochastic discount factors

JEL Codes: D58 D81 Q40

PDF: http://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe1041.pdf

EPRG Paper Link: 1019

Open Access Link: https://doi.org/10.17863/CAM.1096