Incentives for New Investment in a Deregulated Market for Electricity∗

All decisions about investments in new generation, transmission, distributed energy resources and load management are based on expectations about future market conditions. This paper develops an analytical framework for evaluating forward contracts and investment decisions under the assumption that firms are risk averse. A fixed price/fixed quantity delivery contract forms the basis for the portfolio of a Distribution Company (DISCO). It is supplemented by a two-part contract for peaking capacity (A variable charge for real energy delivered and a fixed charge for capacity). The prices and quantities of these contracts are optimized to provide an equilibrium solution between the DISCOs and the Generating Companies (GENCOs) with equal market power for each side of the market. Additional purchases of electricity may be made in a spot market that is characterized by infrequent price spikes during the summer months. These price spikes make the spot market very risky for a DISCO because customers pay a fixed regulated rate to the DISCO. Using a set of realistic assumptions about price behavior in the spot market, the results show that the optimum quantity of capacity contracted by the DISCO is substantially above the average on-peak load for the summer. From the perspective of a potential investor in new generating capacity, the net revenue from a peaking contract is shown to be less than 30% of the level needed to justify the investment. The additional annual premium needed to build 1000MW of new peaking capacity is shown to be much smaller than the equivalent cost of two alternative policies that attempt to make the market give the “right” signals for a new investment. The first policy is to ensure that the annualized capital cost of new peaking capacity can be recovered by increasing the price paid for availability in an ICAP (capacity) market. This higher price is paid for all capacity in the ICAP market and not just for the new investment. The second policy is to allow higher price spikes in the spot market, keeping the average spot price constant. The additional risk faced by a DISCO with higher and more volatile spot prices puts a GENCO in a strong position to extract a substantial risk premium from the DISCO above the expected spot price. This risk premium leads to an increase in the total cost paid by a DISCO when price spikes are allowed. However, the additional cost of investing in new peaking capacity is less than half the corresponding increased cost using higher ICAP payments.