Mitigating Market Incompleteness with Minor Market Distortions: The Case of Negative Spot Prices For Electricity

Ibrahim Abada and Andreas Ehrenmann

Cambridge Working Papers in Economics from Faculty of Economics, University of Cambridge

Abstract: Risk-mitigation instruments are essential for fostering investments in renewable electricity-production assets and their role is all the more important in the case of market incompleteness. At the same time, such instruments may induce distortions of competition, thereby limiting the effectiveness of spot markets. An example of such an effect is the dramatic increase in negative prices observed in many power markets. Some mechanisms that protect investors from risk decouple operating incentives from spot prices, leading to inefficient trading. At the same time, those negative prices incentivize investments in storage. Such distortions have so far been overlooked in most quantitative research focused on market incompleteness. Using a bi-level programming approach, this paper proposes a framework within which to integrate market distortions when analyzing incompleteness. The lower level of the framework models the power economy via an equilibrium formulation of the two-stage investment problem under risk aversion, where agents invest in the first stage before operating in the stochastic second stage. A central planner offers a set of risk-mitigation schemes in the form of Contracts for Difference and price markups to foster investments, but these schemes can distort competitive bidding. On the upper level, the central planner tunes the design of contracts optimally so that social welfare is maximized. We provide an existence result and undertake a thorough numerical simulation inspired by the French power system, which demonstrates the potential for optimally adjusting the risk-mitigation instruments offered to electricity producers to enhance welfare and limit the prevalence of negative prices.

Keywords: Incomplete Markets; Market Distortion; Bi-level Programming; Stochastic Equilibrium Models; Optimal Regulation; Power Markets (search for similar items in EconPapers)
JEL-codes: C72 C73 D81 Q41 (search for similar items in EconPapers)
Date: 2025-03-25
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