Working Paper: CEPR ID: DP13088
Authors: Natalia Fabra
Abstract: I build a simple model to capture the key drivers of investment and pricing incentives in electricity markets. The focus is put on the interaction between market power and investment incentives, and the trade-off it introduces when designing the optimal regulatory instruments. In contrast to the energy-only market paradigm that assumes perfect competition, my model demonstrates that in the presence of market power scarcity prices do not promote efficient investments, even among risk-neutral investors. Combining price caps and capacity payments allows to disentangle the two-fold objective of inducing the right investment incentives while mitigating market power. Bundling capacity payments with financial obligations further mitigate market power as long as strike prices are set sufficiently close to marginal costs.
Keywords: scarcity pricing; market power; capacity markets; reliability options
JEL Codes: L13; L51; L94
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Scarcity Pricing (D49) | Investment Inefficiencies (G31) |
| Market Power (L11) | Underinvestment (G31) |
| Capacity Payments + Price Caps (L97) | Investment Incentives (G31) |
| Bundling Capacity Payments + Financial Commitments (G19) | Investment Incentives (G31) |
| Market Power (L11) | Costs of Procuring Capacity (D24) |
| Costs of Procuring Capacity (D24) | Less Capacity Procured (D24) |