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Capacity Investment and Market-Driven Price Caps In Electricity Markets

I build a continuous-time model of incremental capacity investment in electricity generation by a representative firm with stochastically evolving electricity prices and time-to-build. The model results in a ``market-driven price cap'' on electricity prices at pledged capacity. This cap is increasing in the cost of investment, time-to-build, volatility of electricity prices, and the market price of electricity price risk. The cap is decreasing the elasticity of demand. It is shown that investment only takes place when demand is elastic and that electricity prices can still increase substantially, even after new capacity has been pledged, due to construction delays. This opens up the possibility of welfare-increasing policy intervention.