The forward market dilemma in energy-only electricity markets

Spot prices in energy-only markets, particularly those with high market price caps, are inherently volatile. As a result, forward markets for hedge contracts are a crucial design feature which guides systemic stability and allows the adequate operation of competitive wholesale and retail markets. Hedge contracts have historically been sold by large base, intermediate and peaking generators to risk-neutral and risk-averse energy retailers. However, as the electricity sector decarbonises and intermittent renewable market share rises, baseload plant exit is predictable, and along with them, so does their hedge contract capacity. Many governments are seeking to accelerate the entry of renewable projects through government-initiated two-way fixed price Contracts-for-Differences (CfDs), typically by way of auction. Because government is the counterparty, CfDs are ‘off-market’ and unless carefully designed, can produce a structural shortage of primary issuance hedge contract capacity. We model the forward markets in Australia's National Electricity Market and find structural shortages may materialise if off-market fixed price methods dominate because the CfD forms the ‘primary hedge’ for renewable entrants – and output cannot be prudently hedged twice. Conversely, when on-market PPAs dominate, or government CfDs are structured to be compatible with active forward market participation by renewable entrants, shortages can be eliminated. • New entrant renewables are increasingly facilitated by CfDs. • Wholesale and retail markets rely on liquid forward markets. • Off-market, government-initiated CfD auctions extract hedge capacity. • Falling forward market liquidity exposes retail customers to spot price risk. • CfD auction design should therefore facilitate on-market CfD recycling.