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

• Date: 01 June 2008
• Author: Dominique Finon
• DOI: http://doi.org/10.1111/j.1753-0237.2008.00148.x
• Published date: 01 June 2008

Investment risk allocation in decentralised

electricity markets. The need of long-term

contracts and vertical integration

Dominique Finon

CIRED (Centre International de Recherche, sur I’Environnement et le Développement), 45 bis, avenue de la

Belle Gabrielle, F-94736 Nogent sur Marne Cedex, France

Abstract

None 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 marketf ail-

ures 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 invest-

ments in generation by impeding efficient risk allocation.

Following Joskow’s (2006) line, we developed an empirical analysis of how to secure invest-

ments in generation through vertical arrangements between decentralised generators and large pur-

chasers, 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, indexedprice contract, tolling contract, financial

option) appear to offer effective solutions for risk allocation. Vertical integration appears to be

another effective wayto allocate risk. But it remains an important complementary condition to effi-

cient risk allocation, i.e. that retail competition is sticky or legallylimited in order to have a large part

of risks borne by consumers on the different market segments.

1. Introduction

During the design of the market electricity reforms, the issue of investment in generating

capacity generally received insufficient attention in the reference model for reforms.This

model is a vertically and horizontally de-integrated industry, which facilitates entry and

allows effectivecompetition on each market from wholesale to retail sales, regulation dis-

couraging vertical arrangements and long-term contracts for this purpose. The canonical

business model in generation is the merchant plant, a stand-alone producer that sells all the

production on short-term markets and without a long-term contract and develops its new

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capacities under project financing by non-recourse debt. This insufficient attention was

starkly highlighted by the crises of electricity markets that were partly because of inad-

equate capacity and by the generators’ investment decision to focus on gas generation

technologies, which could create an excessivespecialisation of the technology mix. Then,

after these crises, theoretical and practical considerations on generation investmentlargely

focused on incentives to develop peak generating capacity and to ensure a reserve margin

in order to guarantee reliability,i.e. short-ter m security of supply.An abundant literature is

developing on this issue, in particular on the different ways of capacity payment (see for

instance Oren, 2003; Joskowand Tirole, 2004; Cramton and Stoft, 2006; Joskow,2006; De

Vries, 2007).

But little attention was paid to the conditions for other investments in baseload and

semi-baseload equipment, as untimely development and non-optimal technologymix dis-

torted in favour of low capital intensive technologies does not present the same risks as

inadequacy of total capacity and its impact on system reliability. Problems also arise if

insufficient attention is paid to the institutional and organisational conditions that contri-

bute to investment in different generation technologiesby devising an efficient allocation

of investment risks across the stakeholders able to bear them (Finon,2006). In the decen-

tralised market model, the reference business model in generation is the so-called ‘mer-

chant plant’, i.e. an independent producer, with no supplybusiness, who invests without ex

ante long-term contracting.

In particular, given the difference in both capital intensiveness and possibility to risk

hedging, technology of combined cycle gas turbine (CCGT) appears to be unduly

favoured in the competitors’ investment choices at the expense of more capital intensive

equipment, such as coal thermal plants and nuclear plants, while the respective expected

levelised costs wouldshow a significant advantage in the most likely scenarios of gas price

evolution and CO2cost internalisation policies. Investments in the latter technologies are

more risky for the producers, and they need to have a possibility to transfer part of their

investment risks on the suppliers or on the consumers through vertical arrangements. But

in the decentralised market model, which was and still is considered as the benchmark of

electricity reforms, these arrangements, which are propitious to investments in various

technologies, are hindered by regulation or undermined by the specific competition char-

acters on the wholesale and retail markets.

The consequence will be a non-timely development of capacities and a non-optimal

orientation of the overall technology mix in the different liberalised electricity markets

as new equipment will be added to the fleet of competitors so as to follow the demand

growth and to replace the old ones at the end of their working life. As shown by

Green (2006), if the mix of capacity is wrong and characterised by a lack of baseload

equipment, marginal price will be unduly high during a large part of the year compara-

tively to a situation with an optimal mix; finally, it will be at the expense of the social

Investment risk allocation in decentralised electricity markets 151

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Journal compilation © 2008 Organization of the Petroleum Exporting Countries

surplus, the loss of the consumers being higher than the supplement of net profit of the

producers.

Weaddress here the organisational unsuitability of the de-integrated market model and

the necessity to adapt it to long-term issues of generation investment allowing not only

adequate capacity development, but also optimality of the future technology mix.We first

make some empirical observations on institutional and organisational conditions of gen-

eration investments in different electricity markets since liberalisation to showthat in the

real world, all the successful generation investments have been the case of vertically in-

tegrated producers or of long-term contracts with consumers (suppliers, industrial cus-

tomers), merchant plants without securing vertical arrangements being the exception.

In the second stage, we analyse the theoretical and practical hurdles to investment that

arise in the decentralised market model, in order to set the role of inadequate investment

risk allocation, which is inherent to vertical de-integration of the industry. Thirdly, we

identify the conditions allowing vertical or quasi-vertical arrangements to be set for an

efficient allocation of investment risks, in particular, the way that investors could meet

credible counterparts on the side of the suppliers and customers.

2. Experience of institutional arrangements for capacity developments

on liberalised markets

Reforms were shaped by referring to the de-integrated market model. Regulation discour-

ages and disallows vertical integration and long-term contract between producers and sup-

pliers, and betweensuppliers and consumers and tends to incite historic producers to divest

in generation.1Wefirst turn to empirical observations on experiences of investment in gen-

eration in different liberalised markets in order to confirm the necessity of long-term con-

tracts and vertical arrangements to invest in generation. Putting aside the experience of

developing capacity for peak loads only, the record of investments in generation capacity

after marketliberalisation of the electric industries in the United States and in Europe shows

that institutional conditions of successful capacity development in baseload and semi-

baseload equipment are long-term contracts and vertically integrated company.

2.1. Generation developments in the US markets

It is noteworthy that only half of the US states have liberalised their markets. In the other

half, electricity industries remain in the cost-of-service regulation, but only 10 per cent of

investment has been made there between1997 and 2005 because the market in these states

was mature enough. The US states that liberalise their electricity industry witnessed a

boom of investment in the late 1990s.

Over 230 GW of new generating capacity was added mainly in these states between

1997 and 2005, among which gas turbines for production during peak hours. Two-third

Dominique Finon152

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