Efficiency in wholesale electricity markets: On the role of externalities and subsidies

This paper studies the effects of capacity market reforms that three U.S. grid operators-PJM, ISO-NE, and NYISO-have undertaken in response to state-level subsidies paid to emission-free electricity generation. We first derive an analytical model of energy-and-capacity markets that allows us to predict the price and resource mix effects of such subsidies, as well as to understand their welfare implications. We confirm that subsidies, even when combined with energy consumption taxes, generally cannot achieve first-best outcomes. We also show there exists a range of subsidy rates that are welfare-enhancing when greenhouse gas externalities are taken into account. Finally, we evaluate the capacity market reforms, finding that their justification is misguided and that such reforms are likely to decrease welfare.