Insufficient Incentives for Investment in Electricity Generation

In theory, competitive electricity markets can provide incentives for efficient investment in generating capacity. We show that if consumers and investors are risk averse, investment is efficient only if investors in generating capacity can sign long-term contracts with consumers. Otherwise the uncovered price risk increases financing costs, reduces equilibrium investment levels, distorts technology choice towards less capital-intensive generation and reduces consumer utility. We observe insufficient levels of long-term contracts in existing markets, possibly because retail companies are not credible counter-parties if their final customers can switch easily. With a consumer franchise, retailers can sign long-term contracts, but this solution comes at the expense of the idea of retail competition. Alternative capacity mechanisms to stimulate investment are discussed. 1 We would like to thank anonymous referees and David Newbery, Richard Green, Anette Boom and Gert Brunekreeft for comments. We are gratefull for financial support from ESRC/EPSRC under award number RG37889.