Capacity Choices in Liberalized Electricity Markets

Abstract

We develop a theoretical model of long-run investment decisions on capacity in the context of a liberalized electricity market. The sector’s idiosyncrasies such as the uncertainty surrounding future supply and demand, as well as technological constraints, are explicitly modelled. The model is sufficiently flexible to describe the situation in different systems. We derive the level of capacity that maximizes social welfare, and compare it to a decentralized outcome. We show that in the absence of any regulation, private investment decisions on capacity unambiguously lead to a socially sub-optimal outcome, and we illustrate these results using simulations.