It is now widely recognised that we need to reduce emissions. However, there are many ways to do this, and lots of uncertainty in the decisions to be made.
Most governments handle this by letting the private markets innovate, taking risk in search of profit. In practice, this approach is never as free or natural as some proponents suggest: after all, governments still set the rules as to what private companies can do, and set policies that can influence outcomes. But nonetheless, private investors make a lot of decisions about what technologies to invest in, and where.
However, where outcomes are highly uncertain, and this uncertainty is outside of their control, investors can require unnecessarily high expected returns to take part. I believe this nervousness is under-appreciated when designing policies to attract private investment. And I believe this could be addressed by facilitating better forward markets.
What are forward markets?
Forward markets allow participants to agree to pay or receive money based on the outcome of uncertain future outcomes. For example, an electricity consumer who may otherwise be forced to pay the highly uncertain electricity spot price may enter into a contract where if the price is high, they receive payments, in return for paying if the price is low.
Forward markets can get much more complex than this. Their payoff can take into account other factors, for example, the quantity of wind generation. Or they can include asymmetry, for example paying you money where the price is high but not requiring you to pay money where the price is low.
While forward contracts share some similarities with insurance contracts, they tend to be based on external factors. For example, a forward power contract will tend to be linked to the market power price, rather than the exact price you pay. This adds transparency, although can create what is known as basis risk, when the forward contract’s protection doesn’t quite match your actual situation.
Benefits of forward markets
In order to decarbonise, we need to invest in long term infrastructure: wind turbines, solar PV, battery storage, electrolysers for hydrogen, and nuclear generators. These tend to last for over 20 years, meaning their payoff depends on market outcomes over that entire period. While some of this uncertainty is technical in nature, a lot depends much more on the decisions and actions of government and other market participants. For example, if you invest in a wind turbine and everyone does similarly, whenever your turbines are spinning, there is likely to be a surplus of power and low prices.
Allowing investors to swap uncertain revenue for fixed amounts in the forward markets will allow them to focus on reducing their construction and operating costs. It also reduces their cost of financing, as repayments will not be subject to market revenue uncertainty. This has been especially seen in the UK offshore wind industry, where the availability of Contracts for Difference has enabled rapid expansion.
Another advantage of a forward market is to signal the market expected outcomes. In the case above, a rich forward market would allow investors to see how much revenue a wind farm was expected to generate. A forward market might be more or less believable than forecasts from experts, but more importantly, it could be ‘locked in’ by investors. A rich forward market would go further, allowing investors to see the expected revenue in individual years, not just averaged over a period of, say, 15 years. This would allow them to decide if more wind generation would make economic sense, or if another technology would be better.
Some suggested contracts
I would like to see the following contracts available, at yearly if not monthly granularity, going out at least 30 years:
- A contract that swapped a fixed amount of revenue for the half hourly wind generation multiplied by the half hourly spot price. This would eliminate the market risk for a wind farm. (Note, this is different to a standard Contract for Difference, which still leaves the investor exposed to the uncertainty in the quantity of wind generated.)
- One that swapped a fixed amount of revenue for the half hourly solar generation multiplied by the half hourly spot price. This would eliminate the market risk for a solar farm.
- One that swapped a fixed amount of revenue for the difference between the half hourly spot price and an index price (say the gas price), where this difference was positive. This would eliminate the market risk for a flexible generator.
- One that swapped a fixed amount of revenue for the difference between the four highest spot prices each day and the four lowest spot prices each day. This would reduce the market risk for a battery owner.
There is a tradeoff in designing forward contracts: whether to reference the site’s actual generation or a market index. Most investors, I suspect, would prefer the contract to reference their actual generation or consumption, minimising basis risk. However, my preference would be to reference an objective metric, for example actual wind. My reason for preferring this is that it prevents the seller of the contract from being exposed to your actual site performance, and maintains the investors incentive to operate the facility as productively as possible. For example, if spot prices are negative, you are properly incentivised to switch off your generator.
Forward markets will therefore require creation of appropriate objective proxies that minimise basis risk while ensuring appropriate incentives. Ideally insurance products should exist to help sites manage the resultant basis risk, for example if your generator has a technical outage.
Effort is also needed to ensure that references are robust to policy changes. For example, if Great Britain created distinct prices for England and Scotland, this would disrupt the effectiveness of existing forward contracts. The way to address this is a mixture of thoughtful contract design, some attention paid by government when setting policies, and legal frameworks that allow for fair recalibration when required.
The role of the government
While forward markets can reduce the role government needs to play in deciding how capital is allocated, I’d argue they still play an important role. As mentioned above, they set the rules that govern what private companies can do, and policies (like carbon pricing) that can affect the relative value of different investments. Governments should therefore aim to get the balance right, changing policies where needed to achieve the necessary change, while not changing them arbitrarily.
I suspect there is also a need for governments to assist with credit risk, as commercial banks, for example, would be hesitant to enter into a 20 year forward contract with a small generator, and requiring parties to post margins may is likely to prevent them taking part. This isn’t without risk to the government, but this risk is less than if it was making all the investment decisions itself.