Fuel cost uncertainty, capacity investment and price in a competitive electricity market

Nurit GAL, Irena MILSTEIN, Asher TISHLER, Chi Keung WOO

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16 Citations (Scopus)

Abstract

This paper studies the effect of natural-gas fuel cost uncertainty on capacity investment and price in a competitive electricity market. Our model has a two-stage decision process. In the first stage, an independent power producer (IPP) builds its optimal capacity, conditional on its perceived uncertainties in fuel cost and electricity demand. In the second stage, equilibrium prices and quantities are determined by IPPs competing in a Cournot market. Under the empirically reasonable assumption that per MWh fuel costs are log-normally distributed, we find that a profit-maximizing IPP increases its capacity in response to rising fuel cost volatility. Consequently, the expected profit of the IPP and expected consumer surplus increase with volatility, rejecting the hypothesis that rising fuel cost uncertainty tends to adversely affect producers and consumers. Expected consumer surplus further increases if the IPP hedges the fuel cost risk. However, the IPP's optimal strategy is not to do so. The policy implication of these results is that the government should not intervene to reduce the price volatility of a well-functioning spot market for natural gas, chiefly because such intervention can have the unintended consequence of discouraging generation investment, raising electricity prices, and harming consumers. Copyright © 2016 Published by Elsevier B.V.
Original languageEnglish
Pages (from-to)233-240
JournalEnergy Economics
Volume61
Early online dateNov 2016
DOIs
Publication statusPublished - Jan 2017

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Costs
Natural gas
Profitability
Electricity
Gas fuels
Uncertainty
Power markets
Cost uncertainty
Capacity investment
Electricity market
Consumer surplus
Profit
Cournot
Electricity price
Decision process
Government
Equilibrium price
Electricity demand
Price volatility
Policy implications

Bibliographical note

Gal, N., Milstein, I., Tishler, A., & Woo, C. K. (2017). Fuel cost uncertainty, capacity investment and price in a competitive electricity market. Energy Economics, 61, 233-240.

Keywords

  • Competitive electricity market
  • Natural gas price volatility
  • Generation investment under uncertainty
  • Electricity price