Capacity Mechanisms and Effects on Market Structure

Liberalized electricity markets are characterized by a fluctuating price-inelastic demand, non-storable electricity and often show substantial market shares held by one or few incumbent firms. These characteristics have led to a controversial discussion concerning the need for and the design of capacity mechanisms, which combine some form of capacity payments with price caps in the spot market. The purpose of this study is to understand the effects of different capacity mechanisms on the market structure. We consider a model with a dominant firm and a competitive fringe and investigate the impact of price caps and capacity payments on investment incentives and market shares of both parties. While lower price caps reduce the potential for the exercise of market power in static models, we find that in the dynamic model with endogenous investments lower price caps increase market concentration and the frequency of capacity withholding, as well as, the dominant firm's profits.