Investment decisions in liberalized electricitymarkets: A framework of peak load pricing withstrategic firms

In this article we analyze firms investment incentives in liberalized electricity markets. Sinceelectricity is economically non storable, it is optimal for firms to invest in a differentiatedportfolio of technologies in order to serve strongly fluctuating demand. Prior to theLiberalization of electricity markets, for regulated monopolists, optimal investment andpricing strategies haven been analyzed in the peak load pricing literature (compare Crew andKleindorder (1986)). In restructured electricity markets regulated monopolistic generatorshave often been replaced by competing and potentially strategic firms.This article aims to respond to the changed reality and model investment decisions of strategicfirms in those markets. We derive equilibrium investment for strategic firms and compare tothe benchmark cases of perfect competition and monopoly outcomes. We find that strategicfirms have an incentive to overinvest in base-load technologies but choose total capacities toolow 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, andquantify the potential for market power and its impact on generation portfolios in restructuredelectricity markets in the long run.....