Strategic Forward Trading and Technology
51 Pages Posted: 29 Feb 2016 Last revised: 16 Nov 2018
Date Written: November 16, 2018
We analyze the impact of renewable generation technologies on wholesale electricity prices. It is fundamental that technologies affect market prices via their marginal production costs, and low-cost wind power thus displaces incumbent gas generators' production whenever available. This cost-based merit-order effect forms the theoretical underpinning behind investment decisions and subsidy policies in the power industry. This paper revisits the merit-order effect with the additional consideration of operational factors, in particular the intermittent availability of renewable (wind) power. We adapt the classic Cournot framework to analyze incumbent conventional producers' competition with emerging low-cost intermittent generators. We find that the cost-based merit-order effect is complemented by a further operational effect on price formation. Specifically, since electricity is traded in both spot (product) and forward (financial) markets, wind intermittency alters the value of forward hedge positions, and thereby affects market prices through producers' strategic forward commitments. As a result, intermittency may cause producers to behave less aggressively in forward trading for fear of unfavorable spot-market positions. Equilibrium prices may then paradoxically increase with more wind power, even though both renewables and forward trading are separately viewed as pro-competitive. We further examine how the merit-order effect depends upon other market fundamentals, repeated forward trading, policies influencing renewable producers' participation in forward markets, and additional generation technologies. Our model also provides results that explain previously contradictory empirical effects of fundamentals on power prices. Overall, our analysis suggests that the cost-based merit-order effect alone is insufficient for evaluating the impacts of diverse technologies on power prices.
Keywords: Forward trading, Cournot competition, Electricity markets, Renewable energy
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