Water Misallocation and Environmental Externalities in Electricity Generation

We explore the interactions between environmental externalities and intertemporal market power in electricity generation industries where thermal operators imperfectly compete with operators using scarce water stored in dams. Relying upon a two-period model, we show that, in countries where demand peaks at the first (resp.ly, second) period after water renewal, dynamic market power worsens (resp.ly, ameliorates) resource allocation and environmental health. We then address policy issues. We show that, in general, second best is not decentralized by means of standard tools such as price cap. We argue that the hydraulic process requires specific regulation. We put forward a quantity-based version of the contracts for price difference increasingly used in power pools, to be adopted jointly with either a flexible form of taxation or an intertemporal price cap.