Marginal Cost Pricing in Hydro-Thermal Power Industries: Is a Capacity Charge Always Needed?

This paper explores marginal cost pricing in hydro-thermal power industries. As in standard peak-load pricing for all-thermal electric systems, pricing consists of an energy charge and a capacity charge. However, the marginal cost of hydro generation now includes the value of water, which is determined endogenously. In turn, the capacity charge equals the marginal cost of increasing capacity which depends on the costs of both technologies and on the plant factor of hydro plants relative to the system’s load factor. Moreover, if the cost advantage of the hydro technology is sufficiently high, then the optimal total installed capacity is larger than the system’s maximum demand and henceforth the optimal capacity charge equals zero. JEL Codes: L11, L13, L51, L94.