Rationales for capacity remuneration mechanisms: Security of supply externalities and asymmetric investment incentives

Authors

Jan Horst Keppler

Abstract

Economics so far provides little conceptual guidance on capacity remuneration mechanisms (CRM) in
deregulated electricity markets. Ubiquitous in real-world electricity markets, CRMs are introduced country
by country in an ad hoc manner, lacking the theoretical legitimacy and the conceptual coherence enabling
comparability and coordination. They are eyed with suspicion by a profession wedded to a theoretical
benchmark model that argues that competitive energy-only markets with VOLL pricing provide adequate
levels of capacity. While the benchmark model is a consistent starting point for discussions about electricity
market design, it ignores the two market failures that make CRMs the practically appropriate and theoretically
justified policy response to capacity issues. First, energy-only markets fail to internalize security-of-supply
externalities as involuntary curbs on demand under scarcity pricing generate social costs beyond the private
non-consumption of electricity. Second, when demand is inelastic and the potential capacity additions are
discretely sized, investors face asymmetric incentives and will underinvest at the margin rather than overinvest.
After presenting the key features of the theoretical benchmark model, this paper conceptualizes security of
supply externalities and asymmetric investment incentives and concludes with some consideration regarding
design of CRMs.

Energy Policy 105 (2017)