Risk Spillovers and Hedging: Why Do Firms Invest Too Much in Systemic Risk?

In this paper we show that free entry decisions may be socially inefficient, even in a perfectly competitive homogeneous goods market with non-lumpy investments. In our model, inefficient entry decisions are the result of risk-aversion of incumbent producers and consumers, combined with incomplete financial markets which limit risk-sharing between market actors. Investments in productive assets affect the distribution of equilibrium prices and quantities, and create risk spillovers. From a societal perspective, entrants underinvest in technologies that would reduce systemic sector risk, and may overinvest in risk-increasing technologies. The inefficiency is shown to disappear when a complete financial market of tradable risk-sharing instruments is available, although the introduction of any individual tradable instrument may actually decrease efficiency. We therefore believe that sectors without well-developed financial markets will benefit from sector-specific regulation of investment decisions.investments in productive assets;hedging;systemic risk;risk spillovers

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.

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.

Risk spillovers and hedging: why do firms invest too much in systemic risk?

In this paper we show that free entry decisions may be socially inefficient, even in a perfectly competitive homogeneous goods market with non-lumpy investments. In our model, inefficient entry decisions are the result of risk-aversion of incumbent producers and consumers, combined with incomplete financial markets which limit risk-sharing between market actors. Investments in productive assets affect the distribution of equilibrium prices and quantities, and create risk spillovers. From a societal perspective, entrants underinvest in technologies that would reduce systemic sector risk, and may overinvest in risk-increasing technologies. The inefficiency is shown to disappear when a complete financial market of tradable risk-sharing instruments is available, although the introduction of any individual tradable instrument may actually decrease efficiency. We therefore believe that sectors without well-developed financial markets will benefit from sector-specific regulation of investment decisions.

The Corporate Governance of Central Counterparties and Shareholder Primacy: a Re-Evaluation in the Presence of Systemic Risk

Amidst the catastrophic collapse of Lehman Brothers in September 2008, central counterparties (‘CCPs’) worldwide kept the global securities and derivatives exchanges afloat by rescuing trillions of dollars of trades affected by the bankruptcy. The successful performance of CCPs during the crisis has put them on the regulatory agenda as new financial bulwark against systemic contagion in the over-the-counter (‘OTC’) derivatives market. By guaranteeing the OTC derivatives of a failing institution, the CCP can supposedly prevent the failure of one institution from spreading to its counterparties. In the EU, the European Market Infrastructure Regulation (‘EMIR’) introduced mandatory clearing via CCPs for certain standardised OTC derivatives. However, the centralisation of risks also makes CCPs central nodes in the financial market, whose failure could have devastating consequences for systemic stability. It is therefore essential from a systemic risk perspective that CCPs correctly manage their risk exposure. This lays bare the weakness of the new system: CCPs are in essence private institutions established for furthering the interests of private parties, not the interests of the prudential regulator. The governance challenge in CCPs therefore lies in ensuring that managers take decisions that safeguard their long-term financial stability. This paper contributes to the debate regarding the governance of CCPs by re-evaluating the appropriateness of the predominant view in Anglo-American corporate governance scholarship that a firm should be run in the interests of its shareholders. In particular, the paper argues that CCPs focused on generating revenue for their shareholders do not have the best incentives to prevent systemic risk generated by their activities. This observation has important implications for the design of the governance of CCPs and in particular requires a re-evaluation of the focus on shareholder value maximisation. The paper shows that the current EU regulatory framework fails to deliver in this respect

International transport of captured CO2: Who can gain and how much?

If Carbon Capture and Storage (CCS) is to become a viable option for lowcarbon power generation, its deployment will require the construction of dedicated CO2 transport infrastructure. In a scenario of large-scale deployment of CCS in Europe by 2050, the optimal (cost-minimising) CO2 transport network would consist of large international bulk pipelines from the main CO2 source regions to the CO2 sinks in hydrocarbon elds and aquifers, which are mostly located in the North Sea. In this paper, we use a Shapley value approach to analyse the multilateral negotiation process that would be required to develop such jointly optimised CO2 infrastructure. Using the InfraCCS CO2 pipeline network optimisation tool, we perform numerical simulations on the cost burden allocation of a 28 billion euro CO2 pipeline network, which would be required to reach the EU's 2050 climate goals in the PRIMES-based Power Choices scenario. We analyse two EU pipeline policy cases: one with national pipeline monopolies and one with liberalised pipeline construction. We nd that countries with excess storage capacity capture 38% to 45% of the benets of multilateral coordination, with the higher number corresponding to the case with liberalised pipeline construction. Countries with a strategic transit location capture 19% of the rent in the case of national pipeline monopolies. Finally, liberalisation of CO2 pipeline construction reduces by two-thirds the dierences between countries in terms of cost per tonne of CO2 exported. As a side result of the analysis, we nd that the resource rent of a depleted hydrocarbon eld (when used for CO2 storage) is roughly $1 per barrel of original recoverable oil reserves, or 1 euro per MWh of original recoverable gas reserves. This adds 25-600% to current estimates of CO2 storage cost.JRC.F.6-Energy systems evaluatio

Taxation of nuclear rents: benfits, drawbacks and alternatives

The taxation of nuclear energy is studied using a stylized model of the electricity sector, with one dominant nuclear producer and a competitive fringe of fossil-fuel plants. We show that an unanticipated tax on nuclear production can generate significant government revenue in the short run without disturbing the market, but will harm investment incentives in the long run, especially if the government cannot credibly commit to a future tax rate. Even if the government is capable of credibly committing to an optimal long-run tax, government revenues from the long-run tax will be very low due to the market power of the incumbent. Lifetime extension agreements negotiated with multiple potential players, and competitive auctioning of new nuclear licenses are shown to be the most attractive policies. The analytical results are illustrated with a numerical simulation for the case of Belgium.

Essays on Risk in Energy Economics

Energy markets are characterized by large uncertainties and risks. The annual volatility of the Brent oil price is 28%, meaning that there is a 1-in-3 chance that next year's oil price will be more than 28% higher or lower than this year's price. Similarly, the annual volatility of gas prices for domestic consumers in Belgium/Brussels is 14%. The uncertainty is much larger than in many other goods and services, such as cars, housing, or travel, to name but a few household spending categories. This phenomenon is all the more important since energy is an essential input to many production processes and consumption patterns. The risk in energy markets has several underlying causes: technical, such as the recent application of new techniques that allow for the extraction of ‘shale gas’, which has depressed gas prices in the US; macroeconomic, such as the drop in oil demand following the 2008/2009 global economic crisis, which roughly halved oil prices; and political, such as the Russian-Ukrainian gas crisis in 2006 and 2009, or the first oil shock in the 1970s. Part I of this thesis deals with political risk, and analyzes decisions of resource-rich countries that affect the allocation of energy-related rents. Chapter 2 studies the Russian-Ukrainian gas crisis and how it impacts European import strategies. Chapter 3 investigates the taxation of resource extraction in petroleum-producing countries. Chapter 4 also studies taxation, but focuses on a resource that is mostly exploited in Western countries, namely nuclear power. Chapter 5 also deals with Western countries and explores the possible outcome of potential international negotiations on the distribution of rents arising from a trans-European CO2 pipeline network for Carbon Capture and Storage (CCS). Part II of this thesis investigates how firms can protect themselves against the risks in energy supply, by hedging their exposure. The main challenge in hedging is that energy markets are typically very incomplete, in that not enough different contracts (such as options) exist to enable firms to hedge their exposure completely. Chapter 6 analyzes the effect of market incompleteness on welfare and investment incentives in the specific case of an electricity market with demand uncertainty. Chapter 7 provides a generalization of the theory for a generic market structure with non-specified uncertainty.JRC.F.6-Energy systems evaluatio

Generalized PCM coding of Images

Pulse-code modulation (PCM) with embedded quantization allows the rate of the PCM bitstream to be reduced by simply removing a fixed number of least significant bits from each codeword. Although this source coding technique is extremely simple, it has poor coding efficiency. In this paper, we present a generalized PCM (GPCM) algorithm for images that simply removes bits from each codeword. In contrast to PCM, however, the number and the specific bits that a GPCM encoder removes in each codeword depends on its position in the bitstream and the statistics of the image. Since GPCM allows the encoding to be performed with different degrees of computational complexity, it can adapt to the computational resources that are available in each application. Experimental results show that GPCM outperforms PCM with a gain that depends on the rate, the computational complexity of the encoding, and the degree of inter-pixel correlation of the image.This work was supported by the Spanish Government CYCIT under Grant TEC2009-09146. The work of M. Morbee was supported by the Special Research Fund of Ghent University. The associate editor coordinating the review of this manuscript and approving it for publication was Prof. Zhou Wang.Prades Nebot, J.; Morbee, M.; Delp, E. (2012). Generalized PCM coding of Images. IEEE Transactions on Image Processing. 21(8):3801-3806. doi:10.1109/TIP.2012.2197015S3801380621

Technical and Economic Characteristics of a CO2 Transmission Pipeline Infrastructure

Carbon capture and storage is considered one of the most promising technological options for the mitigation of CO2 emissions from the power generation sector and other carbon-intensive industries that can bridge the transition period between the current fossil fuel-based economy and the renewable and sustainable technology era. CCS involves the capture of CO2 from the sources, the transport CO2 through dedicated pipelines and ships, and the storage of CO2 in geological reservoirs, such as depleted oil and gas fields and saline aquifers, for its permanent isolation from the atmosphere. The development of CCS technologies has increased significantly in the last decades; however, there are still major gaps in knowledge of the cost of capture, transport and storage processes. Pipelines have been identified as the primary means of transporting CO2 from point-of-capture to site where it will be stored permanently but there is little published work on the economics of CO2 pipeline transport and most cost studies either exclude transport costs or assume a given cost per tonne of CO2 in addition to capture costs. The aim of this report is to identify the elements that comprise a CO2 pipeline network, provide an overview of equipment selection and design specific to the processes undertaken for the CO2 transport and to identify the costs of designing and constructing a CO2 transmission pipeline infrastructure.JRC.DDG.F.7-Energy systems evaluatio