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Faculty of Economics

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Holmberg, P. and Ritz, R.

Optimal Capacity Mechanisms for Competitive Electricity Markets

The Energy Journal

Vol. 41: Special Issue

Abstract: Capacity mechanisms are increasingly used in electricity market design around the world yet their role remains hotly debated. This paper introduces a new benchmark model of a capacity mechanism in a competitive electricity market with many different conventional generation technologies. We consider two policy instruments, a wholesale price cap and a capacity payment, and show which combinations of these instruments induce socially-optimal investment by the market. Our analysis yields a rationale for a capacity mechanism based on the internalization of a system-cost externality—even where the price cap is set at the value of lost load. In extensions, (i) we show how increasing variable renewables penetration can enhance the need for a capacity payment under a novel condition called "imperfect system substitutability" , and (ii) we outline the socially-optimal design of a strategic reserve with a targeted capacity payment.

Keywords: Investment, Wholesale electricity market, Capacity mechanism, Capacity auction, Strategic reserve

Author links: Robert Ritz  

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