Center for the Study of Energy Markets

The standard economic model of efficient competitive markets relies on the ability of sellers to charge prices that vary as their costs change. Yet, there is no restructured electricity market in which most retail customers can be charged realtime prices (RTP), prices that can change as frequently as wholesale costs. We analyze the impact of having some share of customers on time-invariant pricing in competitive electricity markets. Not only does time-invariant pricing in competitive markets lead to outcomes (prices and investment) that are not first-best, it even fails to achieve the second-best optimum given the constraint of time-invaraint pricing. We then study a number of policy interventions that have been proposed to address the perceived inadequacy of capacity investment. We show that attempts to correct the level of investment through taxes or subsidies on electricity or capacity are unlikely to succeed, because these interventions create new inefficiencies. We demonstrate that the most common proposal, a subsidy to capacity ownership financed by a tax on retail electricity, is particularly problematic. In contrast, an increase in the share of customers on RTP improves efficiency, though it does not necessarily reduce capacity investment. We demonstrate that the analysis is robust to inclusion of a simple form of reserve capacity.