How do two-way contracts-for-difference affect futures markets? A novel modelling approach of futures market liquidity

In the wake of the energy crisis, EU governing bodies agreed on a reform of the European electricity market. The new regulation stipulates that direct price support must be given to new renewable energy installations in the form of two-way contracts-for-differences (CfDs) (or equivalent). This has raised concerns about potential negative effects on liquidity in long-term electricity markets, but the scientific literature has yet to conduct corresponding analyses. To address this gap, we developed a modelling approach to quantify expected futures market volumes and evaluate resulting churn rates. We demonstrated it for the German electricity futures market and found that in the beginning of the considered period, general market characteristics dictated liquidity developments. Yet, CfDs became increasingly more decisive for the market outcome. We found that the impact of CfDs on liquidity can largely be altered through specific design decisions, such as duration, share, and reference price design. While some measures were more suitable for addressing either minimum or average churn rates, different combinations emerged to be able to reach similar liquidity targets. Lastly, we demonstrate the importance of selecting an appropriate counterfactual for evaluating modelling results and drawing conclusions. • Developed a new model to estimate futures market liquidity under CfDs. • Liquidity stays above critical levels but below historic averages. • CfDs increasingly shape long-term market outcomes. • Liquidity impact depends on CfD design choices. • Counterfactual choice crucial for evaluating CfD market impacts.