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Bilateral Forward Contracts and Spot Prices

Allaz and Vila (1993) have shown that forward markets could mitigate market power and improve efficiency. This paper shows that efficiency-improving effect of forward markets is sensitive to the assumption that market participants behave like rational expectations agents when forecasting prices. The existence of forward contracts could increase spot prices and hurt efficiency if buyers engage in bilateral forward contracts and forward rates are influenced by historic prices. These findings have important policy implications for the electricity industry.

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Energy Specializations: Energy Investment and Finance – Public and Private Risks, Risk Management; Energy Modeling – Energy Data, Modeling, and Policy Analysis; Electricity – Markets and Prices

JEL Codes:
D81 - Criteria for Decision-Making under Risk and Uncertainty
E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination
D42 - Market Structure, Pricing, and Design: Monopoly

Keywords: Bilateral forward contracts, Spot prices, Electricity markets, efficiency, market power mitigation

DOI: 10.5547/ISSN0195-6574-EJ-Vol31-No3-4

Published in Volume 31, Number 3 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.