Long-term Contract Regulation in EU Electricity Markets
Loyola de Palacio Series on European Energy Policy
Chapter 1: The problem of long-term contracts in decentralized electricity markets: an economic perspective
The ‘textbook’ model for liberalization and restructuring of electricity markets has at its core the prescription that all horizontal and vertical market relationships should be de-integrated. In markets where it has been applied to a significant extent, the chronic lack of investment in base load technologies and the complete failure of some fully de-integrated systems, most notably in California, have evidenced a dire need for more durable vertical arrangements, in particular long-term contracts, though under-investment may also arise in vertically integrated systems. Since then, electricity regulators have been increasingly aware of the potential benefits of long-term contracting in the context of (partly or fully) de-integrated markets, not only on long-term generation adequacy but also on wholesale market power mitigation. Whereas at the beginning of liberalization certain countries banned long-term con- tracts to quickly achieve full de-integration (e.g. the UK, California), the same countries are now reconsidering their positive effects and increasingly try to find ways to have a greater share of electricity flows traded on a long-term basis, thereby contradicting the standard prescription. Although the consensus on the ‘textbook’ economic model of competitive reform and the necessity to fully de-integrate vertical supply relationships is slowly starting to erode, the welfare effects of long-term contracts remain ambiguous. This first chapter takes an economic perspective to shed some light on the positive and negative effects of long-term supply contracts in decentralized electricity markets, and how to assess them. It is intended to build the necessary economic foundations for our assessment of the strategy of the Commission in subsequent chapters.
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