A real options approach to generation capacity expansion in imperfectly competitive electricity markets

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This paper proposes a real options approach to generation capacity expansionin imperfectly competitive power markets. Our framework incorporates firmswith different levels of market power; heterogeneous technologies, including renewables,base load and peak load; time-varying short-term demand and renewable supply;and long-term demand uncertainty. A real options model allows us to obtaintechnology-specific thresholds for demand to trigger investment.We apply our modelto the German power market and show that a doubling of current demand triggers renewableinvestment, whereas base load generation requires over 50 times current demandon average. The availability of peak load generation serves to avoid rationingand reduce fluctuations in the electricity price. In the absence of incentive mechanisms,however, demand does not become sufficiently high to trigger investmentin this technology. We investigate at which level capacity payments to peak powerplants prevent rationing without reducing investments in renewables. Furthermore,by accounting for market power, we illustrate that strategic firms do not increasetheir market shares over time but hold back investment until market prices are sufficientlyhigh for price-taking firms to expand capacity. As a result, the intensity ofcompetition increases over time
Original languageEnglish
JournalEnergy Systems
Issue number3
Pages (from-to)515-550
Number of pages37
Publication statusPublished - 2020

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