A Principal-Agent approach to Capacity Remuneration Mechanisms

TL;DR

This paper models electricity capacity remuneration mechanisms using a Principal-Agent framework, designing optimal contracts that incentivize capacity investments while sharing physical and financial risks, especially under high uncertainty.

Contribution

It introduces a novel Principal-Agent approach to capacity remuneration, integrating physical and financial risks into contract design for electricity markets.

Findings

Optimal contracts incentivize capacity investment and risk sharing.

Capacity mechanisms are more necessary under higher demand or production uncertainties.

Numerical results highlight the importance of capacity remuneration mechanisms.

Abstract

We propose to study electricity capacity remuneration mechanism design through a Principal-Agent approach. The Principal represents the aggregation of electricity consumers (or a representative entity), subject to the physical risk of shortage, and the Agent represents the electricity capacity owners, who invest in capacity and produce electricity to satisfy consumers' demand, and are subject to financial risks. Following the methodology of Cvitanic et al. (2017), we propose an optimal contract, from consumers' perspective, which complements the revenue capacity owners achieved from the spot energy market, and incentivizes both parties to perform an optimal level of investments while sharing the physical and financial risks. Numerical results provide insights on the necessity of a capacity remuneration mechanism and also show how this is especially true when the level of uncertainties on demand or production side increases.