In this article we analyze firms investment incentives in liberalized electricity markets. In those markets firms choose to invest in different types of power plants which allow production of electricity at different levels of marginal cost. Since electricity is not storable at reasonable cost, it is optimal for firms to invest in a differentiated portfolio of technologies in order to serve strongly fluctuating demand.1 Prior to the liberalization of electricity markets, regulated monopolists decided on optimal investment and pricing strategies. In the course of liberalizing those markets in Europe and the US, which started in the 1990’s, regulated monopolistic generators have been transformed into competing, but potentially strategically acting firms. The present chapter aims to respond to the changed reality in restructured electricity markets and model investment decisions of strategic firms in those markets.
For a single regulated firm, optimal investment and pricing decisions have been thor- oughly analyzed in the so called peak load pricing literature. All main findings are sum- marized in Crew and Kleindorfer (1986), the first contributions date back to the seminal work of Boiteux (1949) and Steiner (1956). That literature and all its extensions analyze optimal investment and pricing decisions of a single firm whose product is non-storable and demand fluctuates over time. The classical framework allows to determine welfare maxi- mizing investment in a single technology. This was subsequently extended to the case of optimal investment in several technologies under the objective of either welfare, or profit maximization.2 The peak load pricing literature was thus perfectly suited (and widely used) to model investment decisions in electricity markets prior to liberalization, where electricity indeed was supplied by regulated monopolies.
Liberalization of electricity markets, which started in the 1990’s throughout Europe, has changed this picture dramatically. In many countries electricity generation has been opened to competition and regulated monopolistic generators have been transformed into competing firms. Most interestingly, the results obtained in the peak load pricing literature
1Typical industry investment in electricity markets contains for example nuclear, lignite, coal, gas and oil plants. Nuclear and lignite plants are expensive to build but produce at low cost and thus run most of the time. Coal and especially gas and oil plants are less expensive to build, but produce more expensively. They will produce only part of the time in order to serve higher demand and peaks. Compare figure 1 for
an illustration of typical industry marginal cost in Germany, 2006. 2In a so called second best approach this was further extended and allows to determine optimal invest-
ment choice, maximizing any weighted sum of profit and welfare.