Investment in Electricity Markets: Equilibrium Price and Supply Function

In most real options models for evaluating power plants, it is assumed that the price fluctuates stochastically such as a geometric Brownian motion. In actual electricity market, the prices are determined by supply and demand, and the supply and demand balance may cause the price spike. Especially, the supply characteristics, which depend on the type and number of power plants in electricity market, are important factors for the price determination. In this study, we develop the model allowing for supply curve of exponential function and equilibrium quantity which is assumed to follow a geometric mean-reverting process. Thus the electricity price is determined by the supply function and the equilibrium quantity. In these setting, we examine a construction investment for power plants under uncertainty. The optimal investment timing and investment value for power plants are obtained. We show the dependence of the supply characteristics as well as uncertainty on the investment timing. Furthermore, it turns out that the opportunity of investment decreases when the supply curve is steep.