Determining the Optimal Reserve Capacity Margin in Electricity Supply: A Note

The operational reserve capacity margin in electricity is usually determined on the basis of engineering considerations and past experience. The economic theory for optimal pricing offers certain rules for deciding about capacity margins, but the underlying assumptions are strong and restrictive. This paper attempts to determine the optimal reserve capacity margin according to the relative costs, to the firm and to society, of supply shortages. It takes into account the difference between capacity and energy costs and quantifies their impact on the capacity margin.