The Effect of Subsidized Entry in Multi-Unit Capacity Auctions with Allocation Externalities

This paper examines the effect of subsidized entry of electricity generation capacity on the outcome of centralized capacity auctions. Subsidized entry suppresses capacity prices and induces an inefficient allocation of capacity. Subsidized entry also alters the generation portfolio determined by the capacity auction, leading to lower expected electricity prices in subsequent market interactions. These effects reduce total industry profit, but may increase consumer surplus. Consequently, the effect of subsidized entry on the overall level of short-term expected social welfare is ambiguous. Subsidized entry has longterm adverse impacts. The suppressed capacity and electricity prices reduce unsubsidized firms’ incentives to undertake generation capacity investments. The long-term resource adequacy issues associated with insufficient capacity investment may dominate the potential short-term benefits of subsidized entry.