Abstract

The paper is co-authored with Robert Ritz at Judge Business School and EPRG , University of Cambridge.

Capacity mechanisms are playing a growing role as part of electricity market design in Europe, North America and other jurisdictions. Yet their role remains hotly debated with some electricity systems retaining an “energy-only” market design without apparent need for capacity payments. In this paper, we introduce a new model of a capacity mechanism in a market with a continuum of generation technologies. We consider two policy instruments: a wholesale price cap and a capacity payment (or procured capacity volume). We show that some combinations of policy instruments will result in socially optimal market investments. Changing capacity payments and the price cap will only influence investments in peak generation plants. Investments improve system reliability, which is a public good. We find that capacity payments can be used to internalize this externality. We also find that capacity payments can be used to mitigate market power for a given social welfare level.