Securing the public interest in electricity generation markets. The myths of the invisible hand and the copper plate

Two aspects of investment in generation capacity in liberalized electricity markets are investigated: the question of whether investment will be sufficient to meet society’s goals for the reliability of electricity supply (generation adequacy) and the question of how to coordinate investment in electricity generation capacity in a competitive market while bound by the physical requirements and limitations of the electricity networks. The study focuses on the situation in European electricity markets. A number of factors discourage generating companies from investing in a level of generation capacity that is optimal for society as a whole. Due to the limited possibilities for the storage of electricity and the low price-elasticity of demand, electricity prices are highly volatile. This, in addition to the lack of historical trend data (due to the short history of liberalized electricity markets), insufficient transparency and high capital costs, causes investment risk to be high. Investment risk is increased by several sources of regulatory uncertainty. Given these circumstances, it is rational for investors to be cautious. A number of policy options for improving investment incentives and for stabilizing the volume of generation capacity, called capacity mechanisms, are described and analyzed. A policy framework is introduced for evaluating them and deciding on the best policy options for different circumstances. With respect to the issue of coordinating investment in electricity generation capacity with the networks, the consequences of the choice for fixed transmission tariffs in most European countries were investigated. While fixed transmission tariffs are intended to make the market simple and transparent, paradoxically they create the need for several additional measures to compensate for their external effects. Among these, the implementation of a congestion management method ranks among the most necessary measures. The options for congestion management, given the choice for fixed transmission tariffs, are analyzed and compared.