A note on the effects of introducing a market for cash-settled forward contracts on electricity

Abstract

We extend the model of Allaz-Vila (1993) to a setting with uncertainty on the market demand. We study a model in which the forward market can be settled in cash, so that the market is open to risk-averse speculators. We show that the risk attitude of traders on the forward market plays a crucial role in determining the degree of competitiveness of the spot market. This because the market price of risk is positive and depends on the volatility of the spot demand. In markets with highly volatile demand the market price of risk is higher, hence the commitment effect of short-selling forwards showed by Allaz and Vila (1993) is reduced. Our model predicts then that opening a forward market in sectors with high demand uncertainty has a smaller positive impact on efficiency than in sectors with stable demand.