Financial Twins: Adapting Long-term Contract Designs to new Electricity Systems

The energy transition requires massive and costly investments in low-carbon power generation and storage. The private sector, however, is increasingly reluctant to undertake such investments. One of the main reasons is that electricity markets are incomplete: risk-averse investors are facing growing risk factors, but are unable to exchange or mitigate these risks beyond a few years. Hybrid market designs, by adding Capacity Remuneration Mechanisms, Contracts for Difference (CfDs), Power Purchase Agreements, and other financial instruments to the energy spot market, allow a better risk allocation between market agents, and have been shown to efficiently foster investment in new generators. Few studies have, however, quantified their efficiency in future systems with a high penetration of both renewable and storage technologies. The present paper tries to fill this research gap. We first propose to generalize the concept of Financial CfDs introduced in the literature to all assets, including storage and consumption assets, into what we define as Financial Twins: financial contracts that fully replicate physical asset’s profits. We then show that a hybrid market design with one Financial Twin per technology is optimal in a power economy: it allows to reach the first best welfare, risk allocation, and investment decisions. To do so, we develop a two-stage stochastic partial equilibrium model of a power system in which agents invest in the first stage in an uncertain environment before trading electricity in the spot market in the second stage. After formulating the model and deriving some useful properties of Financial Twins, we apply the model to the Spanish electricity market to quantify the combined impacts of various Financial Twins in a real-world situation. We also propose and successfully apply a methodology to rank their added value by computing their Shapley values. Our findings indicate that Financial Twins for generators and demand have a far higher value than those for storage. Since over-the-counter battery contracts can already hedge most of a project’s lifetime, policy makers should thus focus on ensuring adequate hedging for more critical technologies through well-designed Financial Twins.