On the effects of capacity payments in competitive electricity markets: Capacity adequacy, price cap, and reliability

Abstract

This paper employs a two-stage model to assess the consequences of an easy-to-use form of capacity payments in competitive electricity markets. We show that capacity payments increase capacity and expected consumer surplus, with little or no effect on expected social welfare (expected consumer surplus plus expected profits minus the cost of using capacity payments minus expected outage costs). In addition, we demonstrate that capacity payments can substantially reduce or, sometimes, fully eliminate electricity outage costs due to price capping or unexpected failure of some generation capacity. Thus, regulators should consider using this form of capacity payments since, in addition to their favorable effect on consumers and on social welfare, they mitigate the ‘missing money’ problem and increase system reliability.