Advertisement

A real options approach to generation capacity expansion in imperfectly competitive power markets

  • Helene Kvilhaug Brøndbo
  • Axel Storebø
  • Trine Krogh Boomsma
  • Christian Skar
  • Stein-Erik FletenEmail author
Original Paper
  • 5 Downloads

Abstract

This paper proposes a real options approach to generation capacity expansion in imperfectly competitive power markets. Our framework incorporates firms with different levels of market power; heterogeneous technologies, including renewables, base load and peak load; time-varying short-term demand and renewable supply; and long-term demand uncertainty. A real options model allows us to obtain technology-specific thresholds for demand to trigger investment. We apply our model to the German power market and show that a doubling of current demand triggers renewable investment, whereas base load generation requires over 50 times current demand on average. The availability of peak load generation serves to avoid rationing and reduce fluctuations in the electricity price. In the absence of incentive mechanisms, however, demand does not become sufficiently high to trigger investment in this technology. We investigate at which level capacity payments to peak power plants prevent rationing without reducing investments in renewables. Furthermore, by accounting for market power, we illustrate that strategic firms do not increase their market shares over time but hold back investment until market prices are sufficiently high for price-taking firms to expand capacity. As a result, the intensity of competition increases over time.

Keywords

Capacity expansion Competitive power markets Energy systems Real options 

Notes

References

  1. 1.
    Agora Energiewende: Sandbag: The European power sector in 2017. State of affairs and review of currentGoogle Scholar
  2. 2.
    Andresen, T., Parkin, B.: Closing the Book on Nuclear Power Isn’t Easy: QuickTake Q&A. Bloomberg (2016). https://www.bloomberg.com/news/articles/2016-10-03/closing-the-book-on-nuclear-power-isn-t-easy-quicktake-q-a. Accessed 2 May 2017
  3. 3.
    Baldursson, F.M., Karatzas, I.: Irreversible investment and industry equilibrium. Financ. Stoch. 1(1), 69–89 (1996)zbMATHGoogle Scholar
  4. 4.
    Baldursson, F.M.: Irreversible investment under uncertainty in oligopoly. J. Econ. Dyn. Control 22, 627–644 (1998)zbMATHGoogle Scholar
  5. 5.
    Baringo, L., Conejo, A.: Correlated wind-power production and electric load scenarios for investment decisions. Appl. Energy 101, 475–482 (2013) (sustainable development of energy, water and environment systems) Google Scholar
  6. 6.
    Batlle, C., Prez-Arriaga, I.J.: Design criteria for implementing a capacity mechanism in deregulated electricity markets. Util. Policy 16(3), 184–193 (2008)Google Scholar
  7. 7.
    Boomsma, T.K., Meade, N., Fleten, S.E.: Renewable energy investments under different support schemes: A real options approach. Eur. J. Oper. Res. 220(1), 225–237 (2012)MathSciNetzbMATHGoogle Scholar
  8. 8.
    Cramton, P., Ockenfels, A.: Economics and design of capacity markets for the power sector. Zeitschrift für Energiewirtschaft 36(2), 113–134 (2012)Google Scholar
  9. 9.
    Dixit, A.: Entry and exit decisions under uncertainty. J. Polit. Econ. 97(3), 620–638 (1989)Google Scholar
  10. 10.
    Dixit, A.K., Pindyck, R.S.: Investment Under Uncertainty. Princeton University Press, Princeton (1994)Google Scholar
  11. 11.
    Egerer, J., Schill, W.P.: Power system transformation toward renewables: Investment scenarios for Germany. Discussion Paper 1402, German Institute for Economic Research (2014)Google Scholar
  12. 12.
  13. 13.
    ENTSO-E: Load consumption data for Germany. https://www.entsoe.eu/data/data-portal/consumption/Pages/default.aspx. Accessed 21 Feb 2017
  14. 14.
    Fernandes, B., Cunha, J., Ferreira, P.: The use of real options approach in energy sector investments. Renew. Sustain. Energy Rev. 15(9), 4491–4497 (2011)Google Scholar
  15. 15.
    Finon, D., Pignon, V.: Electricity and long-term capacity adequacy: The quest for regulatory mechanism compatible with electricity market. Util. Policy 16(3), 143–158 (2008)Google Scholar
  16. 16.
    Fleten, S.E., Maribu, K., Wangensteen, I.: Optimal investment strategies in decentralized renewable power generation under uncertainty. Energy 55(1), 113–137 (2007)Google Scholar
  17. 17.
    Fraunhofer ISE: Electricity generation in Germany in 2017. Accessed 21 Feb 2017. https://www.energy-charts.de/energy_pie.ht
  18. 18.
    Fraunhofer ISE: Net installed electricity generation capacity in Germany, Accessed 21 Feb 2017. https://www.energy-charts.de/power_inst.htm
  19. 19.
    Gabriel, S.A., Conejo, A.J., Fuller, D., Hobbs, B.F.C.R.: Complementarity modelling in energy markets. Springer, New York (2012)Google Scholar
  20. 20.
    Gahungu, J., Smeers, Y.: A real options model for electricity capacity expansion. European University Institute Working Papers, EUI RSCAS (2012)Google Scholar
  21. 21.
    Greenblatt, J.B., Succar, S., Denkenberger, D.C., Williams, R.H., Socolow, R.H.: Baseload wind energy: Modeling the competition between gas turbines and compressed air energy storage for supplemental generation. Energy Policy 35(3), 1474–1492 (2007)Google Scholar
  22. 22.
    Growitsch, C., Malischek, R., Nick, S., Wetzel, H.: The Costs of Power Interruptions in Germany—an Assessment in the Light of the Energiewende. Working Paper 13/07, Institute of Energy Economics at the University of Cologne (EWI), Köln (2013)Google Scholar
  23. 23.
    Gurobi Optimization, Inc.: Gurobi optimizer reference manual (2016). http://www.gurobi.com. Accessed 21 Feb 2017
  24. 24.
    Hach, D., Spinler, S.: Capacity payment impact on gas-fired generation investments under rising renewable feed-in—a real options analysis. Energy Econ. 53, 270–280 (2016)Google Scholar
  25. 25.
    He, H., Pindyck, R.S.: Investment in flexible production capacity. J. Econ. Dyn. Control 16, 575–599 (1992)zbMATHGoogle Scholar
  26. 26.
    Henriot, A., Glachant, J.M.: Melting-pots and salad bowls: The current debate on electricity market design for integration of intermittent RES. Util. Policy 27, 57–64 (2013)Google Scholar
  27. 27.
    von Hirschhausen, C.: The German “Energiewende”: An introduction. Econ. Energy Environ. Policy 3(2), 1–12 (2014)Google Scholar
  28. 28.
    Hirth, L., Ueckerdt, F., Edenhofer, O.: Why wind is not coal: On the economics of electricity generation. Energy J. 37(3), 1–27 (2016)Google Scholar
  29. 29.
    Hobbs, B.: Linear complementarity models of Nash-Cournot competition in bilateral and POOLCO power markets. In: IEEE Transactions on Power Systems, vol. 16(2) (2001)Google Scholar
  30. 30.
    Hobbs, B.F., Pang, J.: Nash-Cournot equilibria in electric power markets with piecewise linear demand functions and joint constraints. Oper. Res. 55(1), 113–127 (2007)MathSciNetzbMATHGoogle Scholar
  31. 31.
    Hobbs, B.F., Rijkers, F.A.M., Wals, A.F.: Strategic generation with conjectured transmission prince responses in a mixed transmission pricing system–part II: Application. IEEE Trans. Power Syst. 19(2), 872–879 (2004)Google Scholar
  32. 32.
    IEA: Projected costs of generating electricity 2015 (2015). https://www.oecd-nea.org/ndd/pubs/2015/7057-proj-costs-electricity-2015.pdf. Accessed 21 Feb 2017
  33. 33.
    IEA and Nordic Energy Research: Nordic energy technology perspectives 2016 (2016). http://www.nordicenergy.org/wp-content/uploads/2016/04/Nordic-Energy-Technology-Perspectives-2016.pdf. Accessed 21 Feb 2017
  34. 34.
    Janssen, M., Wobben, M.: Electricity pricing and market power–evidence from Germany. Euro. Trans. Electr. Power 19, 591–611 (2009)Google Scholar
  35. 35.
    Jing-Yuan, W.F., Smeers, Y.: Spatial oligopolistic electricity models with Cournot generators and regulated emission prices. Oper. Res. 47(1), 102–112 (1999)zbMATHGoogle Scholar
  36. 36.
    Just, S., Weber, C.: Strategic behavior in the German balancing energy mechanism: Incentives, evidence, costs and solutions. J. Reg. Econ. 48, 218–243 (2015)Google Scholar
  37. 37.
    Karan, M.B., Kazdağli, H.: The development of energy markets in Europe. In: A. Dorsman, W. Westerman, M.B. Karan, Ö. Arslan (eds.) Financial Aspects in Energy: A European Perspective, chap. 2, pp. 11–32. Springer, Berlin (2011)Google Scholar
  38. 38.
    Kitasei, S.: Powering the Low-Carbon Economy: The Once and Future Roles of Renewable Energy and Natural Gas. Worldwatch Institute, Washington, D.C. (2010)Google Scholar
  39. 39.
    Knopf, B., Pahle, M., Kondziella, H., Joas, F., Edenhofer, O., Bruckner, T.: Germany’s nuclear phase-out: sensitivities and impacts on electricity prices and $\text{ CO }_2$ emissions. Econ. Energy Environ. Policy 3(1), 89–105 (2014)Google Scholar
  40. 40.
    Kumbarolu, G., Madlener, R., Demirel, M.: A real options evaluation model for the diffusion prospects of new renewable power generation technologies. Energy Econ. 30(4), 1882–1908 (2008)Google Scholar
  41. 41.
    Lang, C.: Rise in German wholesale electricity prices: Fundamental factors, exercise of market power, or both? IWE Working Paper No 02/06 (2006)Google Scholar
  42. 42.
    Lise, W., Hobbs, B.F., Hers, S.: Market power in the European electricity market—the impacts of dry weather and additional transmission capacity. Energy Policy 36(4), 1331–1343 (2008)Google Scholar
  43. 43.
    Lohmann, T., Rebennack, S.: Tailored Benders decomposition for a long-term power expansion model with short-term demand response. Manag. Sci. 63(6), 2027–2048 (2017)Google Scholar
  44. 44.
    Lucia, J.J., Schwartz, E.S.: Electricity prices and power derivatives: Evidence from the Nordic power exchange. Rev. Deriv. Res. 5(1), 5–50 (2002)zbMATHGoogle Scholar
  45. 45.
    MATLAB: The MathWorks Inc., Natick, Massachusetts, United States (2016a)Google Scholar
  46. 46.
    McDonald, R., Siegel, D.: The value of waiting to invest. Q. J. Econ. 101(4), 707–727 (1986)Google Scholar
  47. 47.
    Montel, Oslo, Norway. https://www.montel.no/. Accessed 21 Feb 2017
  48. 48.
    de Moraes Marreco, J., Carpio, L.G.T.: Flexibility valuation in the Brazilian power system: A real options approach. Energy Policy 34(18), 3749–3756 (2006)Google Scholar
  49. 49.
    Morris, C., Pehnt, M.: The German Energiewende Book. Heinrich Böll Foundation, Berlin (2016)Google Scholar
  50. 50.
    Müsgens, F.: Quantifying market power in the German wholesale electricity market using a dynamic multi-regional dispatch model. J. Indus. Econ. 54(4), 471–498 (2006)Google Scholar
  51. 51.
    Open Power System Data: Conventional power plants in Germany. http://data.open-power-system-data.org/conventional_power_plants/. Accessed 20 May 2017
  52. 52.
    Pfenninger, S., Staffell, I.: Long-term patterns of European PV output using 30 years of validated hourly reanalysis and satellite data. Energy 114, 1251–1265 (2016)Google Scholar
  53. 53.
    Pindyck, R.: Irreversible investment, capacity choice, and the value of the firm. Am. Econ. Rev. 78(5), 969–985 (1988)Google Scholar
  54. 54.
    Pindyck, R.S.: The dynamics of commodity spot and futures markets: A primer. Energy J. 22(3), 1–29 (2001)Google Scholar
  55. 55.
    RAP: Report on the German power system. Tech. rep. (2015). Version 1.0. Study commissioned by Agora EnergiewendeGoogle Scholar
  56. 56.
    Reed, S.: Germany strikes offshore wind deals, subsidy not included. The New York Times (2017). https://www.nytimes.com/2017/04/14/business/energy-environment/offshore-wind-subsidy-dong-energy.html. Accessed 22 May 2017
  57. 57.
    RWE Generation: Power plants in Germany. http://www.rwe.com/web/cms/en/1756472/rwe-generation-se/fuels/location-overview/germany/. Accessed 21 Feb 2017
  58. 58.
    Sarkar, S.: On the investment-uncertainty relationship in a real options model. J. Econ. Dyn. Control 24(2), 219–225 (2000)zbMATHGoogle Scholar
  59. 59.
    Schröder, A., Kunz, F., Meiss, J., Mendelevitch, R., von Hirschhausen, C.: Current and prospective costs of electricity generation until 2050. Data Documentation 68, DIW Berlin, German Institute for Economic Research (2013)Google Scholar
  60. 60.
    Schwartz, E., Smith, J.E.: Short-term variations and long-term dynamics in commodity prices. Manag. Sci. 46(7), 893–911 (2000)Google Scholar
  61. 61.
    Seljom, P., Tomasgard, A.: The impact of policy actions and future energy prices on the cost-optimal development of the energy system in Norway and Sweden. Energy Policy 106, 85–102 (2017)Google Scholar
  62. 62.
    Sensfuß, F., Ragwitz, M., Genoese, M.: The merit-order effect: a detailed analysis of the price effect of renewable electricity generation on spot market prices in Germany. Energy Policy 36(8), 3076–3084 (2008)Google Scholar
  63. 63.
    Staffell, I., Pfenninger, S.: Using bias-corrected reanalysis to simulate current and future wind power output. Energy 114, 1224–1239 (2016)Google Scholar
  64. 64.
    Tangerås, T., Mauritzen, J.: Real-time versus day-ahead market power in a hydro-based electricity market. J. Ind. Econ. (2018) (forthcoming) Google Scholar
  65. 65.
  66. 66.
    Vattenfall: Vattenfall’s power plants. http://powerplants.vattenfall.com/#/view=map/sort=name. Accessed 21 Feb 2017
  67. 67.
    Weigt, H., von Hirschhausen, C.: Price formation and market power in the German wholesale electricity market in 2006. Energy Policy 36, 4227–4234 (2008)Google Scholar
  68. 68.
    Wogrin, S., Centeno, E., Barquin, J.: Generation capacity expansion in liberalized electricity markets: A stochastic MPEC approach. IEEE Trans. Power Syst. 26(4), 2526–2532 (2011)Google Scholar
  69. 69.
    Zhu, L., Fan, Y.: A real options-based CCS investment evaluation model: Case study of China’s power generation sector. Appl. Energy 88(12), 4320–4333 (2011)Google Scholar

Copyright information

© Springer-Verlag GmbH Germany, part of Springer Nature 2019

Authors and Affiliations

  • Helene Kvilhaug Brøndbo
    • 1
  • Axel Storebø
    • 1
  • Trine Krogh Boomsma
    • 2
  • Christian Skar
    • 1
  • Stein-Erik Fleten
    • 1
    Email author
  1. 1.Department of Industrial Economics and Technology ManagementNorwegian University of Science and TechnologyTrondheimNorway
  2. 2.Department of Mathematical SciencesUniversity of CopenhagenCopenhagenDenmark

Personalised recommendations