Competition in Electricity Markets with Renewable Energy Sources∗

This paper studies the effects of the diversification of energy portfolios on the merit order effect in an oligopolistic energy market. The merit order effect describes the negative impact of renewable energy, typically supplied at the low marginal cost, to the electricity market. We show when thermal generators have a diverse energy portfolio, meaning that they also control some or all of the renewable supplies, they offset the price declines due to the merit order effect because they strategically reduce their conventional energy supplies when renewable supply is high. In particular, when all renewable supply generates profits for only thermal power generators this offset is complete — meaning that the merit order effect is totally neutralized. As a consequence, diversified energy portfolios may be welfare reducing. These results are robust to the presence of forward contracts and incomplete information (with or without correlated types). We further use our full model with incomplete information to study the volatility of energy prices in the presence of intermittent and uncertain renewable supplies.