Forward Contracts and Generator Market Power: How Externalities Reduce Benefits in Equilibrium

Research has shown that forward contracts for electricity can reduce market power and increase producer output. This is frequently used as justification for policy interventions requiring that consumers purchase forward capacity, but it is not a sufficient justification because rational consumers can account for market power impacts when making forward contracting decisions. Advocates for capacity markets suggest that they are an important way to reduce generator market power in spot markets, but that reasoning does not explain why consumers would fail to take this rationale into account and under-procure forward contracts in the absence of regulation. This research attempts to fill that gap, by displaying how positive externalities for forward contract procurement can arise: the benefits of forward contracting to reduce market power lead to positive externalities because they are shared by all consumers, not just those who engage in the forward contract. As such, the total forward contracting level and total welfare decreases in the number of load-serving entities serving the consumer market. This insight suggests new areas for additional research, for instance to study empirical evidence of the described effects or to explore relevant policy interventions.