Renewables, allowances markets, and capacity expansion in energy-only markets

Abstract

We investigate the combined effect of an Emissions Trading System (ETS) and renewable energy sources on investments in electricity capacity in energy-only markets. We study the long-term capacity expansion decision in fossil fuel and renewable technologies when electricity demand is uncertain. We model a relevant tradeoff: a higher share of renewable production can be priced at the higher marginal cost of fossil fuel production, yet the likelihood of achieving higher profits is reduced because more electricity demand is met by cheaper renewable production. We illustrate our theoretical results comparing the optimal solutions under a business- as-usual scenario and under an ETS scenario. This illustration shows under which limiting market settings a monopolist prefers to withhold investments in renewable energy sources, highlighting the potential distortionary effect introduced via an ETS. Our conclusions remain unaltered under varying key modelling assumptions.