Capacity Payment Mechanisms and Investment Incentives in Restructured Electricity Markets

I analyze the ability of capacity payment mechanisms to alleviate underinvestment in electricity generation capacity. I derive the optimal capacity payment parameters under two capacity payment mechanisms, when capacity demand is price-elastic and when it is price-inelastic. Price-elastic capacity demand reduces the firms’ abilities to exercise market power, alleviates the bimodal capacity market pricing structure, and reduces the degree of market concentration.Further, at the optimal capacity demand parameters, expected welfare, consumer surplus, and aggregate capacity is higher under the price-elastic demand setting. However, a certain degree of underinvestment in generation capacity persists. These findings support the movement of regulatory policy towards a price-elastic capacity demand regime with market monitoring.