Modelling of power generation investment incentives under uncertainty in liberalised electricity markets

In this paper we discuss the problem of power generation capacity adequacy in restructured and competitive power systems and analyse potential regulatory mechanisms to ensure sufficient supply of electricity. In particular, we look at how uncertainty influences the optimal timing of investments in new power generation capacity. We formulate the power generation investment problem for a decentralised and profit-maximising investor in the electricity market, and implement a stochastic dynamic optimisation model to solve the problem. The long-term development of demand is represented as a discrete stochastic process, which influence future prices and profitability in the electricity market. A real options approach is used to take this long-term uncertainty into account in the investment optimisation. In order to value the operational flexibility of a new power plant we use an electricity price model, where the spot price is a function of load level and installed generation capacity, in addition to short-term uncertainties and temporal fluctuations in the market. The use of physical state variables allows us to include specific characteristics of the electricity spot price, which is closely linked to the balance between supply and demand. In addition, we can model the investor’s additional income from regulatory investment incentives, which can also depend on the system’s total capacity balance. Hence, with the investment model we can analyse the interrelated dynamics of the electricity spot market and additional capacity mechanisms, and in turn its effect on profitability and optimal investment timing for an investor in new power generation. Such analyses are important, not only for investors, but also for regulators who want to design robust electricity markets. In a case study we use the model to analyse the effect of introducing a fixed or dynamic capacity payment in the Nordic power system.