Working Paper: CEPR ID: DP6121
Authors: Paul L. Joskow; Jean Tirole
Abstract: This paper seeks to bridge the gap between economists focused on designing competitive market mechanisms and engineers focused on the physical attributes and engineering requirements they perceive as being needed for operating a reliable electric power system. The paper starts by deriving the (second-best) optimal prices and investment program when there are price-insensitive retail consumers, but when their load serving entities can choose any level of rationing they prefer contingent on real time prices. It then examines the assumptions required for a competitive wholesale and retail market to achieve this optimal price and investment program. The paper analyses the implications of relaxing several of these assumptions. First, it analyzes the interrelationships between regulator-imposed price caps and capacity obligations. It goes on to explore the implications of potential network collapses, the concomitant need for operating reserve requirements and whether market prices will provide incentives for investments consistent with these reserve requirements.
Keywords: electricity; incentives; regulation
JEL Codes: L1; L5; L9
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| regulatory mechanisms (e.g., price caps) (L98) | market outcomes (e.g., investment incentives) (G19) |
| price caps (E64) | inadequate investment in peaking capacity (L97) |
| price caps (E64) | need for capacity obligations (L97) |
| capacity obligations (L97) | restore investment incentives (G31) |
| lack of adequate operating reserves (G33) | systemic failures (P11) |
| market design (D40) | reliability outcomes (C52) |