Capacity expansion in liberalized electricity markets with locational pricing and renewable energy investments

Abstract

We study the long-term incentives for expanding production capacity in liberalized electricity markets. How does electricity market design affect the prices of energy, capacity, and social welfare? And how is this capacity market affected by the geographical features of the electricity market? Should the system operator design the capacity market to provide incentives for investment in renewable technologies? We analyze the conditions under which capacity payments and markets enable higher investment relative to an energy-only market in which generators sell electricity but not capacity. We show that capacity markets benefit consumers and investors by increasing investment and reliability and capping peak prices. We prove that generators benefit from owning a portfolio of peak and baseload plants and show that investment strategies must consider regional capacity auctions. We demonstrate that a capacity payment per technology increases investment in renewable technologies and leads to the early retirement of older, carbon-emitting technologies. Regional capacity investment targets effectively decrease energy prices and significantly increase investment in renewable technologies.