Investment Incentives and Auction Design in Electricity Markets

Abstract

Motivated by the regulatory debate in electricity markets, we seek to understand how market design affects market performance through its impact on investment incentives. For this purpose, we study a two-stage game in which firms choose their capacities under demand uncertainty prior to bidding into the spot market. We analyse a number of different market design elements, including (i) two commonly used auction formats, the uniform-price and discriminatory auctions, (ii) price-caps and (iii) bid duration. We find that, although the discriminatory auction tends to lower prices, this does not imply that investment incentives at the margin are poorer; indeed, under reasonable assumptions on the shape of the demand distribution, the discriminatory auction induces (weakly) stronger investment incentives than the uniform-price format.

Keywords: Electricity, investment, market design, regulatory reform, uniform price and discriminatory auctions

JEL Classification: D44, L10, L5, L94