Capacity expansion, subsidies and market power: A real options approach

Currently, developed countries, chiefly EU and USA, are aiming at developing a more sustainable energy sector, by expanding RES capacity and, in order to achieve that goal, generous subsidies are being paid to foster investments. A Real Options model with a stochastic demand is presented to point out the foundations of policy intervention and the impacts of different support policies in a dynamic context. After describing a model with externalities, which might provide some reasons to speed up investments, some support policies are investigated. Different forms of subsidies alter the size and the timing of investments in different ways. As the expansion of production capacity is a long-run phenomenon, I focus on the long-run expected growth rate of investments under different government interventions and provide simulations to compute the distribution of the accumulated capital over time. It is found that while some of the most common subsidy forms do not boost the growth rate, they also increase volatility of the future installed capital and cause a significant fiscal burden.