Investment Effects of Pricing Schemes for Non-Convex Markets

Abstract

Non-convex markets, such as those organized by electricity system operators, lack uniform clearing prices. To help resolve the incentive compatibility issues that arise when clearing these markets, operators have introduced a variety of price formation and uplift payment schemes. We investigate the impact that the choice of pricing scheme can have on generator entry and exit decisions. Our results suggest that despite the presence of fixed production cost elements, prices derived from marginal costs support the optimal capacity mix. The use of uplift payments to supplement these prices could lead to significant distortion of the capacity mix arising in competitive markets. Pricing schemes designed to reduce the need for uplift payments may at the same time reduce prices, leading to lower levels of capacity in equilibrium. Schemes intended to raise prices, to the extent they eliminate the need for discriminatory side payments, may allow system operators to support a higher level of capacity with less distortion to the capacity mix.