Market design and the cost of capital for generation capacity investment

Authors

Benoit Peluchon

Abstract

We study the impact of market design on the required rate of return asked by investors (the cost of capital) for generation capacity investments. We find that, if the Capital Asset Pricing Model applies and there is a positive correlation between electricity demand and the market return, then different generation technologies have different costs of capital at equilibrium in an Energy­Only setting. We show that peak capacity underinvestment can be explained by financial risk, even in the absence of the so­called “missing­money” problem. Analytic expressions of the equilibrium cost of capital are obtained in a simplified generation capacity expansion model. In order to respect generation adequacy standards, fixed­price contracts or capacity markets should be introduced, as was done in the UK with the Electricity Market Reform. We find that Contracts for Difference (CfDs) or capacity markets lower the equilibrium cost of capital, and thus lead to more capacity investment when perfect competitition applies, as well as to lower expected costs for consumers. As a consequence, these mechanisms should not be seen as subsidies, but as welfare improving market­design reforms. By opposition, strategic reserves are not an efficient capacity mechanism : they have no cost of capital reduction properties and only add costs to an EO design.