The Costs of Counterparty Risk in Long-Term Contracts

This paper examines how buyer counterparty risk—arising from the possibility that buyers renegotiate long-term contracts under the threat of default—distorts market efficiency. We develop a theoretical model showing that the prospect of renegotiation raises contract prices, further increasing the likelihood of renegotiation, and depresses investment. We then assess several policy interventions to promote contract liquidity in the presence of buyer counterparty risk, including public subsidies, financial guarantees, and collateral requirements. While these tools can mitigate price distortions and stimulate investment, they also introduce trade-offs such as moral hazard, reliance on costly public funds, or demand reductions. These insights are particularly relevant in sectors with capital-intensive, long-lived assets exposed to price volatility, notably in electricity markets, where underinvestment in renewable generation may slow down the energy transition and hinder decarbonization goals. Finally, we simulate the Spanish electricity contract market for solar PV to quantify the model’s predictions.