Minimum-cost-based capacity planning: does annualized capital expenditure always yield full cost recovery with marginal pricing? (extended version)

Abstract

This paper compares three ways of dealing with the annualization of investment cost (CapEx) when analyzing minimum-cost capacity expansion planning. The first is the classic single-year annualized cost representation, while the other two extend the study to several years with different CapEx representations. Overall versus annualized cost representation shows some advantages as it does not require fixing a criterion for investment cost annualization. It also provides a coherent definition of long-run cost (or prices) when assuming infinite life companies by modeling residual values. Moreover, overall representation adequately represents the life span of production assets. However, the cost recovery property in marginal pricing, which always holds for annualized cost representation under some reasonable hypothesis, is not satisfied for overall cost representations in some situations. In this paper, the conditions that must be fulfilled to get full cost recovery are analyzed in detail, showing a connection between cost recovery and the presence of investments in the last year of the studied horizon. The problem is analyzed in the framework of electricity generation, but conclusions can be extended to other equivalent production contexts.