Generation Capacity Expansion in a Risky Environment: A Stochastic Equilibrium Analysis

Abstract

We cast models of the generation capacity expansion type formally developed for the monopoly regime into equilibrium models better adapted for a competitive environment. We focus on some of the risks faced today by investors in generation capacity and thus pose the problem as a stochastic equilibrium model. We illustrate the approach on the problem of the incentive to invest. Agents can be risk neutral or risk averse. We model risk aversion through the CVaR of plants' profit. The CVaR induces risk-adjusted probabilities according to which investors value their plants. The model is formulated as a complementarity problem (including the CVaR valuation of investments). An illustration is provided on a small problem that captures several features of today's electricity world: a choice often restricted to coal and gas units, a peaky load curve because of wind penetration, uncertain fuel prices, and an evolving carbon market. We assess the potential of the approach by comparing energy-only and capacity market organizations in this risky environment. Our results can be summarized as follows: a deterministic analysis overlooks some changes of capacity structure induced by risk, whether in the capacity market or energy-only organizations. The risk-neutral analysis also misses a shift towards less capital-intensive technologies that may result from risk aversion. Last, risk aversion also increases the shortage of capacity compared to the risk-neutral view in the energy-only market when the price cap is low. This may have a dramatic impact on the bill to the final consumer. The approach relies on mathematical programming techniques and can be extended to full-size problems. The results are illustrative and may deserve more investigation.