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.

Russian gas imports in Europe: how does Gazprom reliability change the game?.

Europe’s dependence on Russian gas imports has been the subject of increasing political concern after gas conflicts between Russia and Ukraine in 2006 and 2009. This paper assesses the potential impact of Russian unreliability on the European gas market, and how it affects European gas import strategy. We also study to what extent Europe should invest in strategic gas storage capacity to mitigate the effects of possible Russian unreliability. The European gas import market is described by differentiated competition between Russia and a – more reliable – competitive fringe of other exporters. The results show that Russian contract volumes and prices decline significantly as a function of unreliability, so that not only Europe but also Russia suffers if Russia’s unreliability increases. For Europe, buying gas from more reliable suppliers at a price premium turns out to be generally more attractive than building strategic gas storage capacity.

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

Abstract 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.

Russian market power on the EU gas market: can Gazprom do the same as in Urkaine?

In the course of 2006, Gazprom sharply increased gas prices for Ukraine, Belarus, Georgia and Moldova. This paper assesses (i) to what extent Europe is vulnerable to similar use of market power by Russia, and (ii) to what extent the construction of strategic gas storage could help Europe to reduce its vulnerability. The European market for imported gas is described by differentiated Cournot competition between Russia and other – potentially more reliable – suppliers, in particular LNG imports. The results show that Russian market power is limited, because demand is not completely inelastic even in the short run. Moreover, if Russia’s unreliability increases (or if European short-run demand elasticity decreases) Russia gives away more and more of its expected profits to the other suppliers. For Europe, buying gas from more reliable suppliers at a price premium turns out to be more attractive than building storage capacity.

Taxation of nuclear rents: benefits, 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.

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.status: publishe

Russian gas imports in Europe: how does Gazprom reliability change the game?

Europe’s dependence on Russian gas imports has been the subject of increasing political concern after gas conflicts between Russia and Ukraine in 2006 and 2009. This paper assesses the potential impact of Russian unreliability on the European gas market, and how it affects European gas import strategy. We also study to what extent Europe should invest in strategic gas storage capacity to mitigate the effects of possible Russian unreliability. The European gas import market is described by differentiated competition between Russia and a – more reliable – competitive fringe of other exporters. The results show that Russian contract volumes and prices decline significantly as a function of unreliability, so that not only Europe but also Russia suffers if Russia’s unreliability increases. For Europe, buying gas from more reliable suppliers at a price premium turns out to be generally more attractive than building strategic gas storage capacity.status: publishe

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

Abstract 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.status: publishe

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

status: publishe

Optimised deployment of a European CO2 transport network

If CO 2 capture and storage (CCS) is to become a viable option for low-carbon power generation, its deployment will require the construction of dedicated CO 2 transport infrastructure. This paper describes the InfraCCS model, which can determine the likely extent and cost of the optimal least-cost CO 2 transport network at European scale for the period 2015-2050, with 2015 the earliest foreseeable starting date of the CCS projects co-funded by the European Energy Programme for Recovery (EEPR), and 2050 the EU's target date for 80-95% reduction of greenhouse gas emissions. The computation is made possible by a number of methodological innovations compared to previous research, in particular: the use of k-means clustering to reduce the number of nodes in the network; the application of the Delaunay triangulation algorithm for pipeline pre-selection; and the introduction of a mathematically convenient yet realistic new pipeline costing model. The InfraCCS tool is applied to determine the optimal network corresponding to a CCS scenario that ensures near-complete decarbonisation of the European power sector. It is shown that the size of the CO 2 network could range from 11,000 to 17,000km by 2050, requiring 16-36 billion euros investment, with the higher numbers corresponding to the case when onshore aquifers are excluded as potential CO 2 storage sites. Since the model shows that by 2030 more than half of the EU Member States could be involved in cross-border CO 2 transport, international coordination seems crucial for the development of an optimised trans-European CO 2 transport network. © 2011 Elsevier Ltd.status: publishe