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

Authors

Gauthier de Maere d’Aertryckean, Andreas Ehrenmanna, Yves Smeer

Abstract

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.

Energy Policy 105 (2017)