Optimal Price Design in the Wholesale Electricity Market

In this paper, we construct an optimal price design mechanism to determine the equilibrium in the day-ahead electricity market, specifically aimed at solving the uncomfortable conflict between conventional thermal sources (CTS) and renewable energy sources (RES). We find that the actual hourly market design is inadequate to achieve an efficient solution in the presence of a large and increasing share of RES. It is not conducive to catalyzing the correct price signal for future investments and does not take into account welfare considerations. Our proposal for a new market design is based on three main pillars. We state pro-competitive incentives to CTS participation in the market. We take into full account the opportunity cost of RES for society and propose correct price signals on the demand side through an optimal Ramsey pricing scheme. We show an empirical application to the Italian electricity market, using empirical measures of LCOE for RES and empirical estimation of heterogeneous buyers’ behavior. The results show improvement in efficiency and welfare in the Italian electricity market with respect to the existing zonal market prices for suppliers and uniform price for buyers.