Investment Dynamics in Electricity Markets

We introduce a simple strategic dynamic model with random demand growth to investigate the incentives for capacity investments. We study Markovian equilibria where the firms’ decisions depend on the current capacity stock only. For these non-collusive equilibria, unexpected investments allow the firms to increase their market share, but they also generate excess capacity that drastically depresses the spot price. The second effect is stronger and the firms maintain very little excess capacity. In some equilibria, even rationing occurs with positive probability along the equilibrium path. Thus, the market does not provide adequate incentives to ensure ‘security of supply’. Moreover, the tight capacity constraint allows the firms to maintain very high market prices and extract huge rents. Traditionally, the regulator sets the price cap equal to the social cost of a marginal rationing. Our welfare analysis suggest that this value is too high and a different calibration is required to reduce market prices and increase consumer surplus, without affecting the level of investment. ∗ This work was partially supported from NSF grant ECS-0224747.