Merit order effect and strategic investments in intermittent generation technologies

This paper studies the strategic interactions between two electricity generators, the first producing with a \traditional" technology and the second employing a \renewable" technology characterized by the random availability of capacity due to the intermittency of its power source. The competition between the \traditional" and the \renewable" power producers is examined through a modified version of the two stage Dixit model for entry deterrence (Dixit, 1980) with Cournot competition in the post entry stage. The outcome of the game suggests that the \renewable" generator exploits the merit order rule which governs spot electricity markets to invest and produce as if it were a sort of Stackelberg leader. While in most cases producer's preferences over strategies do not depend on the average value of capacity availability, according to the value of this parameter the market may lead to an equilibrium which benefits both the \renewable" producer and the consumers. Given that production of electricity from the renewable source depends on actual weather conditions, the analysis of ex-post payoffs reveals that \renewable" producer's preferences over strategies may be reversed for small errors in the forecasting of the true value of the average capacity availability factor when the investment cost in the renewable technology is relatively low. In this case, the incentives for strategic behaviour of the \renewable" producer may be even stronger. The main insights of the model seem to be barely sensitive to changes in the market power of competitors: even when the \renewable" generator behaves as a competitive fringe in the spot market, it is able to infuence equilibrium outcome to its own advantage through investment choices although to a smaller degree than in the standard setting.