Investment risk allocation in decentralised electricity markets. The need of long‐term contracts and vertical integration

Abstract

National audienceNone of the far-reaching experiments in electricity industry liberalisation was able to ensure the timely and optimal capacity mix development. The theoretical market model features market failures due to the specific volatility of prices, and the difficulty of creating complete markets for hedging. In this paper, we focused on a specific failure, i.e. the impossibility of allocating the various risks borne by the producer onto suppliers and consumers in order to allow capacity development. Promotion of short-term competition by mandating vertical de-integration tends to distort investments in generation by impeding efficient risk allocation.Following Joskow's (2006) line, we developed an empirical analysis of how to secure investments in generation through vertical arrangements between decentralised generators and large purchasers, suppliers or consumers. Empirical observations as risk analysis shows that adopting such arrangements may prove necessary. Various types of long-term contracts between generators and suppliers (fixed-quantity and fixed-price contract, indexed price contract, tolling contract, financial option) appear to offer effective solutions for risk allocation. Vertical integration appears to be another effective way to allocate risk. But it remains an important complementary condition to efficient risk allocation, i.e. that retail competition is sticky or legally limited in order to have a large part of risks borne by consumers on the different market segments

When Does Electricity Price Cap Regulation Become Distortionary?

“…When energy‐only markets were first established, generators and retailers were structurally separated and based on a ‘merchant model’. As Finon () explains, the canonical supply‐side business model in deregulated energy markets was the ‘merchant power producer’, a stand‐alone generator that sold its production to the spot and short‐term forward markets (that is, without long‐term PPAs), underpinned by non‐recourse project finance. In this ideal world, the counterparties to merchant power producers were expected to be stand‐alone retailers that buy all their requirements from spot and short‐term forward markets.…”

“…But, by the mid‐2000s, widespread financial distress and bankruptcies of merchant plant in energy‐only markets around the world changed the market for power project finance. From this point, merchant plant relying on 2–3 year hedge contracts for entry became completely unbankable, something Finon () has described as ‘market failure’. This in turn sprouted an entire field of literature in energy economics on ‘resource adequacy’ (see, for example, Oren ; Joskow and Tirole ; Cramton and Stoft ; Joskow ; De Vries ; Finon ; Simshauser ; Caplan ; Nelson and Simshauser ).…”

From First Place to Last: The National Electricity Market's Policy-Induced ‘Energy Market Death Spiral’

“…As Joskow () noted in the United States, from 1997 to 2005, about 230,000 MW of generation capacity was added or acquired, most of which was merchant plant relying on project finance. By 2005, fully 123,000 MW was in financial distress or bankrupt (Finon ). Nelson and Simshauser () noted that in Australia, 10 project‐financed generators were sold or restructured due to financial distress, while Steed and Laybutt () observed the NEM's $50 billion merchant generation fleet (that is, the fleet of power stations operating in the competitive wholesale electricity market) had incurred economic losses of $6 billion over the decade to 2010.…”

“…See Bidwell and Henney () or Finon () for an excellent discussion on resource adequacy and a least‐cost plant mix in energy‐only markets.…”

Long-term energy supply contracts in European competition policy: Fuzzy not crazy

“…First, LTC facilitate entry and thus contribute to market building if spot prices are volatile, when they are sufficiently long and when they can cover sufficiently high volumes (Green and Newbery, 1993, Green and Newbery;1997, Newbery, 1998. The second positive effect is not only that it facilitates investment and thus contribute to 6 long-term generation adequacy, it is also that it may contribute to fuel mix diversity by facilitating investments in base load technologies such as nuclear or coal (Finon and Perez, 2008). Indeed, the greater the fixed costs are, the greater are price and quantity risks (Roques et al, 2005;Finon and Roques, 2008).…”