The Costs of Counterparty Risk in Long-Term Contracts

This paper investigates the implications of counterparty risk - stemming from potential defaults or renegotiations by buyers - on long-term contract markets. It develops a theoretical model highlighting how opportunistic buyer behavior leads to higher contract prices and underinvestment, potentially leading to the collapse of the contract market. The paper also evaluates public-policy interventions, including public subsidies, financial guarantees, regulator-backed contracts, and collateral requirements. While these measures can reduce price-related inefficiencies and promote investment, they involve trade-offs such as moral hazard or the reliance on costly public funds. These findings are particularly relevant for sectors with capital-intensive, long-lived assets exposed to price volatility, especially electricity markets, where underinvestment in renewable energy could delay the energy transition and hinder carbon-abatement goals. Simulations using data for the Spanish electricity market are used to quantify the theoretical predictions of the model.