Economics of Electricity System II: Electricity price caps and capacity markets

The electricity market reform in Japan aims to simultaneously achieve both energy security and economic efficiency by creating balancing and capacity markets in addition to the wholesale power market that already exists. Of the two markets, this paper focuses on the capacity market and analyzes its fundamental issues using a deterministic electricity network model. Ensuring security of electricity supply may require government intervention because of price caps that are used to alleviate market power and a variety of market failures that result in excessively high costs of electric power investment. The central task of this paper is to study how to design the capacity market to ensure there will be sufficient capacity to meet demand. Another major topic is the cost-benefit analysis of transmission investment in the presence of the capacity market. When there is no price cap and electricity prices are optimally determined, the revenue from price differences caused by transmission constraints equals the benefit of transmission expansion. We study how this must be changed when a capacity market is introduced.