Renewable Power and Electricity Prices: The Impact of Forward Markets

38 Pages Posted: 29 Feb 2016 Last revised: 9 Mar 2022

See all articles by Heikki Peura

Heikki Peura

Imperial College Business School

Derek W. Bunn

London Business School

Date Written: July 7, 2020

Abstract

Increasing variable renewable power generation (e.g., wind) is expected to reduce wholesale electricity prices by virtue of its low marginal production cost. This merit-order effect of renewables displacing incumbent conventional (e.g., gas) generation forms the theoretical underpinning for investment decisions and policy in the power industry. This paper uses a game-theoretic market model to investigate how intermittently available wind generation affects electricity prices in the presence of forward markets, which are widely used by power companies to hedge against revenue variability ahead of near-real-time spot trading. We find that in addition to the established merit-order effect, renewable generation also affects power prices through forward-market hedging. This ``forward'' effect reinforces the merit-order effect in reducing prices for moderate amounts of wind generation capacity, but mitigates or even reverses it for higher capacities. For moderate wind capacity, uncertainty over its output increases hedging, and these higher forward sales lead to lower prices. For higher capacities, however, wind variability conversely causes power producers to behave less aggressively in forward trading for fear of unfavorable spot-market positions. The lower sales counteract the merit-order effect, and prices may then paradoxically \emph{increase} with wind capacity despite its lower production cost. We confirm the potential for such reversals in a numerical study, suggesting new empirical questions while providing potential explanations for previously contradictory observed effects of market fundamentals. We conclude that considering the conventional merit-order effect alone is insufficient for evaluating the price impacts of variable renewable generation in the presence of forward markets.

Keywords: Forward trading, Cournot competition, Electricity markets, Renewable energy

Suggested Citation

Peura, Heikki and Bunn, Derek W., Renewable Power and Electricity Prices: The Impact of Forward Markets (July 7, 2020). Available at SSRN: https://ssrn.com/abstract=2738703 or http://dx.doi.org/10.2139/ssrn.2738703

Heikki Peura (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

Derek W. Bunn

London Business School ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
0207 000 8000 (Phone)

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