Contents lists available at ScienceDirect Energy Policy journal homepage: www.elsevier.com/locate/enpol Investment with incomplete markets for risk: The need for long-term contracts ☆ Gauthier de Maere d’Aertrycke a , Andreas Ehrenmann a, ⁎ , Yves Smeers b a ENGIE, Brussels, Belgium b Université de Louvain, Louvain la Neuve, Belgium ARTICLE INFO Keywords: Incomplete markets Risk functions Investment in electricity markets Long term contracts Capacity markets ABSTRACT Barring subsidies, investment in the power generation sector has come to an almost complete halt in the restructured European power sector. Market and regulatory failures such as the well known missing money (see Joskow, (2006)) but also normal market features such as risk, possibly also affected by market failures like market incompleteness are mentioned as common causes for the situation. This paper discusses incomplete risk trading and its impact on investment. The analysis applies computable stochastic equilibrium models on a simple market model of the Energy Only type. The paper first compares the cases of complete and fully incomplete markets (full risk trading and no risk trading). It continues by testing the impact of different risk trading contracts on both welfare and investment. We successively consider Contracts for Difference, Reliability Options with and without physical back up that we add to our Energy Only market model. We test the impact of market liquidity on the results. Finally, we compare these methods to a Forward Capacity Market that we also add to the energy only model. We complete the paper by interpretation of these results in terms of hurdle rate implied by these risk-trading situations. 1. Introduction European investment in non-subsidized generating capacities has now come to an almost complete halt. Recent years have even seen a shift from investing to mothballing and anticipative retiring of tech- nologically advanced plants. Various reasons explain this evolution. The familiar “missing money”, the lower demand due to the economic situation and energy conservation as well as several market imperfec- tions are often mentioned. The uncertainty surrounding the restructur- ing and energy transition processes and the economic recovery also play a role. We focus on long-term demand risk in energy only markets (EOM) and discard other considerations. The importance of risk in investment pervades corporate finance since the early days of Management Science. Valuations of risky assets can roughly be classified in two major approaches. One is based on the so-called Capital Asset Pricing Model (CAPM) and is mainly used for long-term investment. The other is based on contingency pricing and the literature of derivative pricing: it is commonly applied for hedging short and medium-term operations (see Cochrane (2005) for an extensive discussion of both approaches and Eydeland and Wolyniec (2003) for the application of derivative pricing to power and gas). Derivative pricing is also used to value flexible power plants. “Reliability options” is a particularly original application of derivatives to remedy the missing money (Vasquez et al. (2002), Oren (2005), Chao and Wilson (2004) and more recently Pöyry (2015) and several other authors). CAPM and contingency pricing are technically different but com- monly applied under similar fundamental assumptions: both rely on exogenous (econometrically estimated) price processes and risk pre- mium. Both also generally neglect issues of market incompleteness (see Magill and Quinzii (2002) for an extensive treatment in finite hor- izons). These simplifications were probably sufficient in the past but may now be inadequate in the highly uncertain context of the restructured power market. This paper contributes to the literature by presenting different stochastic equilibrium problems to quantify the impact of risk, market incompleteness and contracts in investment in power generation. These models are easily interpretable in standard investment criteria and are treated in a single computational framework. We illustrate the approach on a stylized stochastic equilibrium investment problem for which we assume exogenous processes of fundamentals (such as demand and fuel costs). In contrast with most of the literature, we http://dx.doi.org/10.1016/j.enpol.2017.01.029 Received 27 June 2016; Received in revised form 18 January 2017; Accepted 19 January 2017 ☆ Disclaimer: The views set out in this study are those of the authors and do not necessarily reflect the opinion of ENGIE. ⁎ Corresponding author. E-mail addresses: gauthier.demaeredaertrycke@engie.com (G. de Maere d’Aertrycke), andreas.ehrenmann@engie.com (A. Ehrenmann), yves.smeers@uclouvain.be (Y. Smeers). Energy Policy 105 (2017) 571–583 Available online 26 January 2017 0301-4215/ © 2017 Published by Elsevier Ltd. MARK