DP6121 Reliability and Competitive Electricity Markets

Author(s): Paul L Joskow , Jean Tirole

Publication Date: February 2007

Keyword(s): electricity , incentives , regulation

JEL(s): L1 , L5 , L9

Programme Areas: Industrial Organization

Link to this Page: www.cepr.org/pubs/dps/DP6121.asp.asp

This paper seeks to bridge the gap between economists focused on designing competitive market mechanisms and engineers focused on the physical attributes and engineering requirements they perceive as being needed for operating a reliable electric power system. The paper starts by deriving the (second-best) optimal prices and investment program when there are price-insensitive retail consumers, but when their load serving entities can choose any level of rationing they prefer contingent on real time prices. It then examines the assumptions required for a competitive wholesale and retail market to achieve this optimal price and investment program. The paper analyses the implications of relaxing several of these assumptions. First, it analyzes the interrelationships between regulator-imposed price caps and capacity obligations. It goes on to explore the implications of potential network collapses, the concomitant need for operating reserve requirements and whether market prices will provide incentives for investments consistent with these reserve requirements.