The Economics of Electricity Markets

10Market-Based Investment in Electricity Generation

Chapter 9 addressed the question of the computation of the socially efficient level of investment in generation and consumption assets. However, if we are to exploit the benefits of competitive markets, we would like to know if we can decentralise these investment decisions to private entrepreneurs. Is it the case that decentralised investment decisions by private entrepreneurs will lead to an efficient level of investment?

10.1 Decentralised Generation Investment Decisions

In Chapter 9, we derived the conditions that an omniscient central planner would follow to make optimal investment decisions. Now let us ask the question whether those outcomes can be achieved through decentralised decisions by private generation entrepreneurs.

As in Chapter 9, we will maintain the following assumptions:

• There are a number of distinct generator technologies, each with a constant variable cost;
• There are constant returns to scale in each technology, with a distinct fixed cost of adding capacity for each generation type;
• Capacity can be added in arbitrarily small increments (i.e. there is no ‘lumpiness’ in generation investment) and there is no limit on the volume of capacity that can be added of any one generation type; and
• There are no sunk costs – capacity can be added or withdrawn at will.

We will assume that there are a large number of independent generation entrepreneurs. Since each can make an arbitrarily small investment in the ...