CSEM WP 164 An Equilibrium Model of Investment in Restructured Electricity Markets

In this paper, we describe a framework for modeling investment in restructured electricity markets. This framework is extremely flexible, and is designed to be able to capture many of the key considerations that distinguish investment in deregulated electricity markets from both investment in regulated markets, and investment in competitive markets for other commodities. The model is composed of two distinct elements: a detailed model of short-run, or ‘spot market’ competition in electricity markets, and a dynamic long-run equilibrium model of investment decisions of firms. The investment choices by firms will be driven by the underlying profits implied by the short-term markets under different investment paths. Firms will choose the investment paths that lead them to more profitable states of short-term markets. We implement the framework for a representative electricity market and several qualitative insights can be demonstrated. First, the incentives of individual firms to invest depends strongly upon their position in the market. Second, the impact of market structure on investment incentives is also influenced by the firms’ contractual or retail obligations in the market. Just as long-term contracts or retail obligations change a firm’s incentives in the short-term markets, so do they influence investment decisions. Third, increased uncertainty – in our case in demand growth – can delay investment. This is a demonstration of the option value of waiting for further information before making an irreversible investment. ∗Bushnell: University of California Energy Institute. E-mail: [email protected]. Ishii: Department of Economics, University of California, Irvine. E-mail: [email protected]. This research was partially supported by the Midwest Independent System Operator.