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Bilateral Forward Contracts and Spot Prices

Abstract:
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: L11: Production, Pricing, and Market Structure; Size Distribution of Firms, D40: Market Structure, Pricing, and Design: General, D42: Market Structure, Pricing, and Design: Monopoly, D21: Firm Behavior: Theory, D22: Firm Behavior: Empirical Analysis, Q41: Energy: Demand and Supply; Prices

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.