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In the electricity sector a major political concern is reliability captured by the phrase 'keeping the lights on'.

This has led several countries to create capacity mechanisms of different sorts for example in the form of capacity markets. Generators are paid not for their production of electricity but rather for their promise to have ready a certain amount of capacity.

Free markets are assumed incapable of delivering reliability due to what is commonly referred to as the missing money problem.

The missing money problem arise when peaker plants are not sufficiently rewarded on wholesale markets of electricity resulting in underinvestments in capacity.

My question is: What in theory is the source of this missing money problem?

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    $\begingroup$ The issue was revealed in the February 2021 Texas power crisis when demand exceeded supply (and lights went off) despite wholesale prices rising to $\$9000$/MWh compared to a more usual $\$25$/MWh. This was seen as having two politically undesirable effects: those customers whose retail prices were linked to wholesale prices saw massive short-term bills while customers whose retail prices were not so directly linked failed to reduce demand sufficiently. So politics was the cause of the missing money. $\endgroup$
    – Henry
    Commented Jul 22 at 8:24
  • $\begingroup$ I think it is an interesting case. As far as I have been able to find out one argument is the argument from 'demand side flaws' - (1) demand is very priceinelastic and (2) there is no automatic rationing - even if production is lower than consumption, the consumers are not automatically excluded from consuming - instead blackout occurs. However, from a theoretical point of view unless demand is perfectly inelastic equilibrium exist. That the price is very high does not show markets do not work. But, obviously, from a political point of view, this could be the conclusion - Texas case in point. $\endgroup$
    – Jesper Hybel
    Commented Jul 22 at 8:43
  • $\begingroup$ @Henry How is politics the cause of the Texas power crisis? In more sensible places politics regulates that there are some capacity providers as described in the question. In Texas politics just let the free market do its thing and that caused the power crisis because the free market didn't deliever reliability. $\endgroup$
    – quarague
    Commented Jul 22 at 9:46

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I am not an expert in energy economics nor urban economics, please excuse my ignorance. But I guess you can explain this phenomenon as a problem of insufficient provision of public good. In a word, electricity capacity has positive externality and cannot be internalized using a profit-maximization model and hence is insufficiently provided.

E.g., let's say it is profit maximizing (e.g., by $p = MC(x)$) for all the generators to only invest in building $x$ unit of capacity in total, but the market demand is $2x$ during peak hours, at an affordable price. The free market solution has to left half of lights off. To solve the problem, the government may need to set up a market for generator capacity, as you mentioned. This helps the generators to internalize the positive externality and provide more public good (capacity). You can also think of this as taxing the low-capacity producers and subsidize the high-capacity ones.

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  • $\begingroup$ I agree. The argument based on the idea of reliability being a public good definitely has relevance '+1'. Not sure this is the only argument though. Thx. for drawing my attention to this matter. $\endgroup$
    – Jesper Hybel
    Commented Jul 22 at 8:32
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    $\begingroup$ Could you explain in more detail why you consider electricity capacity is a public good? Note that the standard definition of a public good is a good that is non-excludable and non-rival. $\endgroup$
    – Adam Bailey
    Commented Jul 22 at 10:27
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    $\begingroup$ @Adam Bailey, I think that is a fair question. Let me just add that as far as I have understood it is not the capacity that is considered a public good but the reliability. I guess the basic argument - short of local demand overload - is that reliability is a system property. Everyone benefits from the low frequency of blackouts and none can be excluded. Obviously, flexibility markets - where consumers are paid to accept potential decoupling from the grid - are then one way to try circumvent this problem. $\endgroup$
    – Jesper Hybel
    Commented Jul 22 at 11:31
  • $\begingroup$ @JesperHybel Great point, I agree with you that the actual public good is the reliability but not capacity itself. I was roughly arguing about the problem where good with positive externality is under provided, not public good, using the most rigorous definition. I appreciate that Adam Bailey pointed this out. $\endgroup$
    – DiZ
    Commented Jul 22 at 15:44

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