Investment with incomplete markets for risk: The need for long-term contracts☆

Barring subsidies, investment in the power generation sector has come to an almost complete halt in the restructured European power sector. Market and regulatory failures such as the well known missing money (see Joskow, (2006)) but also normal market features such as risk, possibly also affected by market failures like market incompleteness are mentioned as common causes for the situation. This paper discusses incomplete risk trading and its impact on investment. The analysis applies computable stochastic equilibrium models on a simple market model of the Energy Only type. The paper first compares the cases of complete and fully incomplete markets (full risk trading and no risk trading). It continues by testing the impact of different risk trading contracts on both welfare and investment. We successively consider Contracts for Difference, Reliability Options with and without physical back up that we add to our Energy Only market model. We test the impact of market liquidity on the results. Finally, we compare these methods to a Forward Capacity Market that we also add to the energy only model. We complete the paper by interpretation of these results in terms of hurdle rate implied by these risk-trading situations.

[1]  A. Soyster,et al.  Electric Utility Capacity Expansion Planning with Uncertain Load Forecasts , 1982 .

[2]  Dominique Finon,et al.  Electricity and long-term capacity adequacy: The quest for regulatory mechanism compatible with electricity market , 2008 .

[3]  Yves Smeers,et al.  Generation Capacity Expansion in a Risky Environment: A Stochastic Equilibrium Analysis , 2011, Oper. Res..

[4]  Petra Heijnen,et al.  The impact of electricity market design upon investment under uncertainty: The effectiveness of capacity mechanisms , 2008 .

[5]  J. Neumann,et al.  Theory of games and economic behavior , 1945, 100 Years of Math Milestones.

[6]  E. Centeno,et al.  Long Term Issues to Be Addressed by Regulators in Liberalised Electricity Systems: Generation Adequacy and Indicative Planning: Justification, Available Mechanisms, and a Simulation Study on Some Concrete Policies , 2009 .

[7]  Shmuel S. Oren,et al.  Generation Adequacy via Call Options Obligations: Safe Passage to the Promised Land , 2005 .

[8]  Yves Smeers,et al.  Liquidity risks on power exchanges: a generalized Nash equilibrium model , 2013, Math. Program..

[9]  Yves Smeers,et al.  Risk Trading and Endogenous Probabilities in Investment Equilibria , 2015, SIAM J. Optim..

[10]  Hugh Rudnick,et al.  Auction approaches of long-term contracts to ensure generation investment in electricity markets: Lessons from the Brazilian and Chilean experiences $ , 2010 .

[11]  William W. Hogan,et al.  ON AN "ENERGY ONLY" ELECTRICITY MARKET DESIGN FOR RESOURCE ADEQUACY , 2005 .

[12]  L. D. Vries,et al.  Generation adequacy: Helping the market do its job , 2007 .

[13]  J. Laffont,et al.  THE DYNAMICS OF INCENTIVE CONTRACTS , 1988 .

[14]  I. Pérez-Arriaga,et al.  A Market Approach to Long-Term Security of Supply , 2002, IEEE Power Engineering Review.

[15]  Dawn Hunter,et al.  An integrated CVaR and real options approach to investments in the energy sector , 2008 .

[16]  Yves Smeers,et al.  Stochastic Equilibrium Models for Generation Capacity Expansion , 2010 .

[17]  J. Morbée,et al.  Risk Spillovers and Hedging: Why Do Firms Invest Too Much in Systemic Risk , 2011 .

[18]  A. Eydeland,et al.  Energy and Power Risk Management: New Developments in Modeling, Pricing, and Hedging , 2002 .

[19]  Bailey,et al.  Asset Pricing , 2017, Encyclopedia of GIS.

[20]  Philippe Artzner,et al.  Coherent Measures of Risk , 1999 .

[21]  D. Newbery,et al.  Fuel mix diversification incentives in liberalized electricity markets: A Mean–Variance Portfolio theory approach , 2008 .

[22]  P. Joskow.  Competitive Electricity Markets and Investment in New Generating Capacity , 2006 .

[23]  Yves Smeers,et al.  On the multiplicity of solutions in generation capacity investment models with incomplete markets: a risk-averse stochastic equilibrium approach , 2017, Math. Program..