Dario Lucarella*, Massimo Gallanti*, Michele Benini*, Alberto Gelmini* 26th USAEE/IAEE North American Conference, Energy in a world of changing costs and technologies. Ann Arbor, 24-27 Settembre 2006 * CESI RICERCA The problem of “resource adequacy”, i.e. the structural capability of the system to meet the electric energy demand respecting pre-defined security and quality levels, has become a critical issue in most liberalized electricity markets. In theory, in a perfectly competitive market, electricity prices should provide sufficient economic signals to market players so that they are incentivized enough both to keep in service power plants that work only during few peak hours and to invest in new generation capacity when necessary. In practice, due to several reasons (“political” unsustainability of high prices, investors’ risk aversion, uncertainties for new investments due to possible litigations with local communities, short term demand inelasticity, informative asymmetries, etc.), real markets need specific mechanisms (capacity payments) aimed at explicitly remunerating generation capacity, in order to ensure its adequacy over time and to avoid both high electricity price volatility and so- called “boom-and-bust” investment cycles, where periods with low reserve margins and high prices alternate to periods with excess of generation capacity and low prices. Different mechanisms have been applied worldwide, ranging from fixed payments administratively defined, such as in Spain, to specific uplifts to power pool prices, proportional to the loss of load probability and to the value of lost load, such as in the old England & Wales electricity market, to the “capacity obligation” markets of the PJM, New York and New England electricity markets, where load serving entities are obliged to buy from producers an amount of generation capacity sufficient to meet their peak load plus a pre-defined reserve margin. Taking advantage of the experiences above, new approaches to support generation resource adequacy in liberalized electricity markets have been proposed, such as the one based on “call options” devised by the Italian Electric Energy and Gas Regulatory Authority. This approach has been evaluated using an electricity market simulator able to model the electric system evolution, the investment dynamics and the related electricity prices over a long-term time horizon. To this aim, the simulator features a short-term cycle, where competition on electricity prices and quantities traded either on the power exchange or bilaterally is modeled, nested inside a long-term cycle, where competition on investments in new generation capacity is simulated. The proposed approach is compliant with the requirements defined by the Italian Legislation for a national capacity market, whose implementation is currently under discussion.