Dynamic Storage Operation Under Uncertainty and the Reliability Externality: Implications for Capacity Investments

Abstract

Energy storage is increasingly relied upon to meet short-term demand uncertainties from renewable variability and electrification. Unlike conventional generators, storage's contribution to reliability is policy-dependent and balances near-term arbitrage against future scarcity risk. We study how demand uncertainty alters such dynamic storage operation and how these operating decisions propagate into long-run investment outcomes. We formulate storage operation as an average-cost Markov decision process and embed the resulting stationary policies into a stylized capacity expansion framework. Demand uncertainty induces a precautionary storage policy which hedges against stochastic scarcity, leading to materially different post-storage demand distributions relative to perfect-foresight benchmarks. We additionally demonstrate that the reliability externality characteristic of electricity markets interacts with uncertainty in a manner that uniquely distorts both storage operation and investment.