Price caps and investment: long-run effects in the electric generation industry

Abstract

This paper utilizes a dynamic framework to determine the long-run effects of price caps on electricity generation investment and spot prices. The results show that the effects of spot market price caps differ significantly based upon the market structure. In a social welfare maximization scenario, price caps will not reduce average electricity prices and may actually raise them due to the dynamic affect of price caps on investment. In addition, price caps may reduce overall investment levels and result in welfare losses if the independent system operator is forced to shed load. Therefore, since social welfare maximization will approximate a competitive outcome, the results imply that price caps should be avoided in competitive markets. In contrast, for the monopoly producer, price caps produce an indeterminate effect on overall investment, and unequivocally lower average prices, which are otherwise unbounded. Therefore, price caps are necessary to prevent unlimited price markups.