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

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 dynamic storage operation and how those operating decisions propagate into long-run investment outcomes. Storage operation is formulated as an average-cost Markov decision process, and the resulting stationary policies are embedded in a stylized capacity expansion framework. Demand uncertainty induces a precautionary storage policy that hedges against stochastic scarcity, producing materially different post-storage demand distributions than perfect-foresight benchmarks. We further show that the reliability externality characteristic of electricity markets interacts with uncertainty in a way that uniquely distorts both storage operation and investment.