Wholesale Electricity Markets and Generators’ Incentives: An International Review

Under regulation both short-run decisions regarding the operation of power plants and long-run decisions on investment in generating capacity were made by vertically integrated utilities, either regulated or owned by the state. Generating units were remunerated on an average-cost basis through rates determined by the regulatory process. The transition to a deregulated environment in the US, Europe, and other parts of the world, has dramatically changed the short- and long-run incentives faced by private generating companies. This chapter reviews critical properties of electricity markets and elements of market design applied in wholesale electricity markets around the world that affect generators' incentives for pricing and operation, as well as for investment in generating capacity. Case studies from various electricity markets have been used to illustrate the law of unintended consequences. Flaws in electricity market design that allow generators to engage in market manipulation have often resulted in a very speedy and significant transfer of wealth from customers to producers, as happened during the power crisis in California in 2000 (Borenstein et al. 2002; Sweeney 2002). Flaws in certain elements of market design aimed at aligning investment incentives may promptly result in over- or underinvestment in generating capacity. The critical design elements include the organization of wholesale markets for electric energy. What we think of as the 'electricity market' is actually a number of submarkets in energy (both spot and forward), operating reserves, transmission congestion...