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The Visible Hand: Ensuring Optimal Investment in Electric Power Generation

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This article formally analyzes the various corrective mechanisms that have been proposed and implemented to alleviate underinvestment in electric power generation. It yields three main analytical findings. First, physical capacity certificates markets implemented in the United States restore optimal investment if and only if they are supplemented with a "no short sale" condition, i.e., producers can not sell more certificates than they have installed capacity. Then, they raise producers' profits beyond the imperfect competition level. Second, financial reliability options, proposed in many markets, are effective at curbing market power, although they fail to fully restore investment incentives. If "no short sale" conditions are added, both physical capacity certificates and financial reliability options are equivalent. Finally, a single market for energy and operating reserves subject to a price cap is isomorphic to a simple energy market. Standard peak-load pricing analysis applies: under-investment occurs, unless production is perfectly competitive and the cap is never binding.

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Energy Specializations: Energy and the Economy; Energy Investment and Finance – Project Finance; Energy Investment and Finance; Electricity – Local Distribution; Electricity – Transmission and Network Management; Electricity – Generation Technologies

JEL Codes:
Q43 - Energy and the Macroeconomy
G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
O16 - Economic Development: Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
D44 - Auctions
Q2 -

Keywords: Imperfect competition, Market design, Investment incentives

DOI: 10.5547/01956574.37.2.tlea

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Published in Volume 37, Number 2 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.