First principles, market failures and endogenous obsolescence: the dynamic approach to capacity mechanisms

Authors

Jan Horst Keppler

Abstract

The theoretical benchmark model arguing that competitive energy-only markets with VOLL pricing can provide sufficient levels of capacity is a coherent starting point also for discussions about capacity remuneration mechanisms (CRMs). Two types of market imperfection, both stemming from the non-storability of electricity and the resultant inelasticity of demand, however require qualification of the benchmark model and can justify CRMs. The first type of market imperfection relates to the existence of security-of-supply externalities as involuntary curbs on demand under VOLL-pricing create disutility beyond the private non-consumption of electricity. In interconnected economies, utility does not only depend on individual electricity consumption but also on the smooth consumption of others. These externalities are captured in the difference between voluntary and involuntary demand response. The second type of market imperfection relates to the asymmetric incentives for investors under imperfect information. Due to the inelasticity of demand and the lumpiness of generating equipment, investors in markets for non-storable goods will err on the side of caution, underinvesting at the margin rather than overinvesting. There exists thus not an intrinsic, general case but a time- and context-specific case for CRMs depending on the shape of the load-curve, the elasticity of demand and the availability of flexibility resources. The choice of mechanism will depend on the number of hours of potential capacity short-falls and the resulting capital-intensity of the technologies most apt to respond to them. Most importantly, well-designed CRMs will set in motion the very structural dynamics towards more elastic demand, a development that might one day make them obsolete and render the theoretical benchmark model applicable again. CRMs thus require transparent and pre-announced review mechanisms at regular intervals.