Market Structure and Equilibrium in a Hydro Dominated Electricity Market

Hydro generation plays an important role in electricity generation, especially in countries like New Zealand where 60 to 65 percent of electricity is generated in the hydro sector. In contrast to other types of electricity generation, for example gas generation, hydro generation has two unique properties: uncertainty regarding future resource availability and the ability to store the nature resource. Although hydro resource is often considered to be ‘free’, the ability to store creates an endogenous hidden marginal cost of water: usage today entails the loss of the ability to be used in future periods. Therefore pricing in a hydro dominated electricity market should be different from the approaches applied in markets that consist of generation methods that use only non-storable resources. This paper introduces a tractable approach to model a hydro dominated electricity market that incorporates inter-temporal decision making. It enables us to compute the equilibrium outcomes and the endogenous hidden marginal cost of water under different market structures.