Motivated by the increase in variable renewable energy (such as wind and solar) generation, we study a day-ahead electricity market that consists of finitely many competing firms, each facing supply uncertainty. Each firm commits to a price-contingent production schedule in the day-ahead market, and chooses its actual production quantity after the day-ahead market is cleared and the firm’s available supply is realized. If a firm produces less than its cleared production commitment, the firm pays an undersupply penalty in proportion to its underproduction. We investigate two cases regarding overproduction: each firm either receives a credit or pays a penalty in proportion to its overproduction. Using differential equations theory, we explicitly characterize the firms’ committed production schedules and actual production strategies in equilibrium with and without subsidies. The purpose of an undersupply penalty is to improve system reliability by motivating each firm to commit to a production schedule it can deliver in the production stage. We prove that imposing or increasing a market-based undersupply penalty rate can result in a strictly larger production commitment at all prices for each firm in equilibrium, thereby resulting in a strictly lower equilibrium system reliability and day-ahead price with probability 1. We also show that linking penalties (and credit) to the price in a common electricity market results in maximum degradation of the system reliability (due to a higher undersupply penalty rate).

Areas of Focus: Energy Markets
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Energy Markets
Well-functioning markets are essential for providing access to reliable, affordable energy. EPIC research is uncovering the policies, prices and information needed to help energy markets work efficiently.
Electric Power
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Electric Power
As the electric power system faces new pressures and opportunities, EPIC research is working to identify the mix of policies needed to accelerate the global transition to clean, reliable, affordable...
Energy Efficiency
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Energy Efficiency
Improving energy efficiency is lauded as a promising way reduce emissions and lower energy costs. Yet, a robust body of research demonstrates that not all efficiency investments deliver. EPIC faculty...
Renewable Energy
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Renewable Energy
Lower technology costs and supportive public policies are driving an increase in renewable energy in markets around the world. EPIC research is assessing the costs, benefits, and efficiency of policies...