Investment risk allocation in restructured electricity markets

Summary : None of the far-reaching experiments in electricity industry liberalization proved able to ensure the timely and optimal capacity mix development. The theoretical market model features failures attributable to the specific volatility of prices, the difficulty of creating complete markets for hedging, and we focus on this failure in this paper, the impossibility of transferring the various risks borne by the producer onto suppliers and consumers in order to allow development of capacity. Promotion of short term competition by mandating vertical de-integration tends to distort investments in generation by impeding efficient risk allocation. In the line followed by Joskow (2007), we develop an empirical analysis of the way of securing investments in generation by vertical arrangements between de-integrated generators and large purchasers, suppliers or consumers. Empirical observations of risk analysis show that the adoption of these arrangements may prove necessary. Various types of long-term contracts between generators and suppliers (fixed-quantity fixed-price contract, indexed price contract, tolling contract, financial option) appear to offer effective solutions of risk allocation. Vertical re-integration appears to be another effective way to allocate risk. But it remains an important complementary condition to efficient risk allocation: that retail competition is sticky or legally limited in order to transfer a large part of risks to consumers on the different market segments.

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