Proposal for a Simple Mechanism to Encourage Capital Investment in Electricity Generation Capacity: Illusion or Reality?

Abstract

Market prices make it possible to realise returns on capital investments in the electricity sector, but these prices may not necessarily be politically or socially acceptable. As a result, explicit or implicit price caps may be established. If these caps are effective, they may result in loss of income and therefore discourage investors. To remedy this problem, several mechanisms have been proposed and put into place. The goal of this paper is not to perform an analysis of these initiator mechanisms for capital investment but, rather, to study an alternative. We show that this conceptually simple mechanism, which appears to correspond to the desires of producers and suppliers, is actually an illusion. Admittedly, the mechanism allows a single producer (or multiple producers with the same production mix) to recover its (their) costs despite the price cap. However, it does not allow certain technologies to be profitable. As a result, producers may be reluctant to invest in these technologies. This reluctance is more significant with the introduction of risk. The mechanism creates a distortion, moving money from peak to base technologies. Furthermore, it is not simple to implement.