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Investment decisions in Liberalized Electricity Markets: A framework of Peak Load Pricing with strategic rms

Gregor Zoettl

University of Cologne

CORE - Universite´ Catholique de Louvain

May 5, 2008

bstract In this article we analyze firms investment incentives in liberalized electricity mar- kets. Since electricity is economically non storable, it is optimal for firms to invest in a di erentiated portfolio of technologies in order to serve strongly fluctuating demand. Prior to the Liberalization of electricity markets, for regulated monopolists, optimal investment and pricing strategies haven been analyzed in the peak load pricing lit- erature (compare Crew and Kleindorfer (1986)). In restructured electricity markets regulated monopolistic generators have often been replaced by competing and poten- tially strategic firms.

This article aims to respond to the changed reality and model investment decisions of strategic firms in those markets. We derive equilibrium investment for strategic firms and compare to the benchmark cases of perfect competition and monopoly outcomes. We find that strategic firms have an incentive to overinvest in base–load technologies but choose total capacities too low from a welfare point of view. By fitting the framework to a specific electricity market (Germany) we are able to empirically analyze Investment choices of strategic firms, and quantify the potential for market power and its impact on generation portfolios in restructured electricity markets in the long run.

Keywords: Investment Decisions, Technology Choice, Restructured Electricity Markets, Peak Load Pricing, Strategic Firms.

We thank Rabah Amir, Claude d’Aspremont, Michael Bartels, Eric van Damme, Andreas Ehrenman, Veronika Grimm, Axel Ockenfels, Jean Pierre Ponssard, Yves Smeers, Achim Wambach, and Hannes Weigt as well as seminar participants at Berlin, Brussles and Cologne for helpful comments and suggestions.

  • University of Cologne, Albertus-Magnus-Platz, D-50923 K¨oln, Germany, zoettl@wiso.uni-koeln.de


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