Efficiency in Wholesale Electricity Markets: On the Role of Externalities and Subsidies

We evaluate the effects of homogeneous subsidies granted for emission-free electricity generation on market outcomes and social welfare. We use an analytical model to assess the conditions under which such subsidies increase efficiency of wholesale energy and capacity markets. While the subsidies, even when combined with energy consumption taxes, cannot achieve first-best outcomes when there are resources with heterogeneous emission intensities, there exists a range of subsidy rates that are welfare-enhancing when greenhouse gas externalities are taken into account. We also derive the conditions under which generation subsidies do not affect the equilibrium price in capacity markets. Finally, we evaluate the capacity market reforms that are being undertaken in the U.S. in response to these kinds of subsidies.