Electricity capacity expansion in a Cournot duopoly

Abstract

This paper adopts a real options approach to analyze marginal investments in power markets with heterogeneous technologies and time-varying demand. We compare the investment behavior of two firms in a Cournot duopoly to a central planner’s when two categories of power plants are available; base and peak load power plants. We find that producers exercise market power and the prices increase. Furthermore, the peak load plants become relatively more valuable and the share of installed peak load capacity exceeds the peak load share in a perfectly competitive market. In a numerical example, we show that this results in welfare losses above 10 %, and significantly larger reduction in the consumer surplus. Further, we examine the effect of analyzing power markets without time-varying demand and find that this underestimates investments in peak load capacity.