Insufficient Incentives for Investment in Electricity Generation

In theory, competitive electricity markets can provide incentives for efficient investment in generating capacity. We show that if consumers and investors are risk averse, investment is efficient only if investors in generating capacity can sign long-term contracts with consumers. Otherwise the uncovered price risk increases financing costs, reduces equilibrium investment levels, distorts technology choice towards less capital-intensive generation and reduces consumer utility. We observe insufficient levels of long-term contracts in existing markets, possibly because retail companies are not credible counter-parties if their final customer can switch easily. With consumer franchise, retailers can sign long-term contracts, but this solution comes at the expense of the idea of retail competition. Alternative capacity mechanisms to stimulate investment are discussed

Retail Competition and Electricity Contracts

Long-term contracts for electricity can counter market power and reduce prices in short-term markets. If electricity retailers face competition, however, companies signing long-term contracts are exposed to the risk that a fall in short-term prices would allow rivals to buy on the spot market and undercut them. Could this lead to less contracting and higher prices? This paper combines a model of electricity retailing and a Cournot model of competition in the wholesale markets to estimate the size of this effect, and finds that it could raise wholesale prices by two or three percent

Retail Competition and Electricity Contracts

Long-term contracts for electricity can counter market power and reduce prices in short-term markets. If electricity retailers face competition, however, companies signing long-term contracts are exposed to the risk that a fall in short-term prices would allow rivals to buy on the spot market and undercut them. Could this lead to less contracting and higher prices? This paper combines a model of electricity retailing and a Cournot model of competition in the wholesale markets to estimate the size of this effect, and finds that it could raise wholesale prices by two or three percent.Electricity, contract markets, retail competition

Risk management in electricity markets: hedging and market incompleteness

The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices by buying and selling derivatives. This paper studies how welfare and investment incentives are affected when markets for derivatives are introduced, and to what extent this depends on market completeness. We develop an equilibrium model of the electricity market with risk-averse firms and a set of traded financial products, more specifically: forwards and an increasing number of options. Using this model, we first show that aggregate welfare in the market increases with the number of derivatives offered. If firms are concerned with large negative shocks to their profitability due to liquidity constraints, option markets are particularly attractive from a welfare point of view. Secondly, we demonstrate that increasing the number of derivatives improves investment decisions of small firms (especially when firms are risk-averse), because the additional financial markets signal to firms how they can reduce the overall sector risk. Also the information content of prices increases: the quality of investment decisions based on risk-free probabilities, inferred from market prices, improves as markets become more complete Finally, we show that government intervention may be needed, because private investors may not have the right incentives to create the optimal number of markets.

Risk management in electricity markets: hedging and market incompleteness.

The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices by buying and selling derivatives. This paper studies how welfare and investment incentives are affected when markets for derivatives are introduced, and to what extent this depends on market completeness. We develop an equilibrium model of the electricity market with riskaverse firms and a set of traded financial products, more specifically: forwards and an increasing number of options. Using this model, we first show that aggregate welfare in the market increases with the number of derivatives offered. If firms are concerned with large negative shocks to their profitability due to liquidity constraints, option markets are particularly attractive from a welfare point of view. Secondly, we demonstrate that increasing the number of derivatives improves investment decisions of small firms (especially when firms are risk-averse), because the additional financial markets signal to firms how they can reduce the overall sector risk. Also the information content of prices increases: the quality of investment decisions based on risk-free probabilities, inferred from market prices, improves as markets become more complete Finally, we show that government intervention may be needed, because private investors may not have the right incentives to create the optimal number of markets.

Market completeness: how options affect hedging and investments in the electricity sector.

The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices by buying and selling derivatives. This paper studies how welfare and investment incentives are affected when an increasing number of derivatives are introduced. It develops an equilibrium model of the electricity market with risk averse firms and a set of traded financial products, more specifically: a forward contract and an increasing number of options. We first show that aggregate welfare (the sum of individual firms' utility) increases with the number of derivatives offered, although most of the benefits are captured with one to three options. Secondly, power plant investments typically increase because additional derivatives enable better hedging of investments. However, the availability of derivatives sometimes leads to ‘crowding-out’ of physical investments because capital is being used more profitably to speculate on financial markets. Finally, we illustrate that players basing their investment decisions on risk-free probabilities inferred from market prices, may significantly overinvest when markets are not sufficiently complete.

Generation Adequacy and Investment Incentives in Britain: from the Pool to NETA

Three years after the controversial change of the British market design from compulsory Pool with capacity payments to decentralised energy-only New Electricity Trading Arrangements (NETA) market framework, we compare the two designs in terms of investment incentives. We review the biases of the Pool capacity payments design, the drought of investment following the introduction of NETA, and the reaction of the market during the first “stress-test” of NETA during the winter 2003. In an energy-only market such as NETA, it is essential that price signals are right and the system operator has a crucial role in contracting ahead for reserve. We recommend that NETA adopt a single marginal imbalance price as dual imbalance pricing distorts price signals in times of scarcity. The lack of long-term contracting that causes hedging and financing difficulties for power projects can becompensated by vertical and horizontal reintegration at a cost of increased market power

Derivatives and Default Risk

Upstream producers that possess market power, sell forwards with a lengthy duration to regional electricity companies (REC). As part of the liberalization of the electricity market, RECs have been privatized and exposed to a possible bankruptcy threat if spot prices have fallen below their expected value. The downstream firms’ expected profit is larger, when it is less likely to be bailed out, the effect on upstream profits is ambiguous while consumers loose. Options are less welfare increasing than forwards, but the difference is minimal. In the presence of bankruptcy, options are the preferred welfare maximizing market instrument