Investment Cost Recovery

Problem

Bid = VC < AC → capital must be recovered from the margin $P - VC$ .

Other units set the price: when a more expensive plant is marginal, every cheaper plant earns $P - VC$ per MWh (= producer surplus / inframarginal rent).
Demand sets the price: in scarcity, supply runs out and price rises to consumers’ willingness to pay. The most expensive (peak) plant recovers its capital only in these hours.

→ Therefore in long-run equilibrium, each plant type recovers its average cost.

VoLL (Value of Lost Load) = social cost of interruptions. Efficient scarcity price can rise up to VoLL.
Price cap protects consumers who don’t know when prices are high.
Dilemma: cap too low → peak plants can’t recover capital → less investment → Capacity Mechanisms
Scarcity prices also create incentives for capacity withholding → Market Power.

= generation adequacy: enough capacity to meet demand (no blackouts).

Energy-only market: no payment for capacity → scarcity price spikes are the investment signal
Efficient optimum: LRMC of the peak plant = VoLL → security of supply is < 100% (if demand is inelastic)

Why an energy-only market may not deliver security of supply

Price cap too low (below VoLL) → peak plants can’t recover capital → missing money → under-investment
Regulatory uncertainty (CO2, nuclear, coal phase-out policy) → investors wait
Other uncertainty (demand, renewables, fuel prices) → scarcity prices hard to forecast
Risk aversion / risk asymmetry: investors prefer too little capacity (high prices) over too much (losses); society the opposite
Investment cycles: long lead times → boom and bust
Reserve capacity is a public good: one grid → everyone gets the same security → no one pays for spare capacity → Public Goods

Price risk → long-term fixed-price contracts with buyers (bilateral contracts).

Links: Merit Order, Plant Economics, Economic Profit