Beyond capacity: contractual form in electricity reliability obligations

TL;DR

This paper analyzes how different resource adequacy contract designs in electricity markets influence investor behavior, resource mix, and market efficiency, proposing policy adjustments to improve market outcomes.

Contribution

It develops a stochastic equilibrium model to compare the effects of various contractual regimes on investment and market structure in electricity markets.

Findings

Alternative contracts can influence investor risk responses

Allowing opt-outs can prevent market inefficiencies

Replacing capacity mechanisms with forward contracts may enhance efficiency

Abstract

Liberalized electricity markets often include resource adequacy mechanisms that require consumers to contract with generation resources well in advance of real-time operations. While administratively defined mechanisms have most commonly taken the form of a capacity obligation, efficient markets would feature a broad array of arrangements adapted to the risk profiles and appetites of market participants. This article considers how the financial hedge embedded in alternative resource adequacy contract designs can induce different responses from risk-averse investors, with consequences for the resource mix and market structure. We construct a stochastic equilibrium model describing a competitive market with incomplete risk trading and compute investment equilibria under different contracting regimes. Two policy recommendations result. First, to avoid creating inefficiency by crowding out other forms of risk sharing, system operators should allow resources contracted through other means to opt out of mandatory capacity mechanisms, with their contribution to those requirements subtracted from administratively defined demand curves. Second, if they wish to promote a single contractual form, regulators should consider replacing existing option-like capacity mechanisms with a shaped forward contract for energy. Beyond these recommendations, we discuss the tension that liberalized systems face in seeking to promote both reliability and competitive outcomes.