Caps-and-floors for long duration storage and firming: contract design under risk and price asymmetry

This article examines the design and valuation of cap-and-floor hedge contracts in hybridised electricity markets, with a focus on their interaction with merchant price risk and project finance structures. Cap-and-floor or 'collar' mechanisms have emerged as a prominent policy instrument to support long-duration storage and firming investment by enhancing project bankability. We show that when investments are financed under leveraged project finance constraints, the value of a profit -sharing collar contract is driven primarily by its ability to truncate left-tail revenue risk rather than its risk -neutral fair value. As a result, collars are likely to be provided to investors at prices that differ materially from actuarial fair valuations in order to meet financing requirements. Incorporating imperfect foresight and empirically calibrated heavy-tailed price forecast errors, we demonstrate that downside dispersion plays a central role in determining debt sizing and investment incentives. Moreover, by examining re-contracting potential, we find the presence of centrally provided profit -sharing collars may materially reduce participant incentives to participate in forward derivative markets, weakening one of the commonly cited advantages of the structure. Overall, it emphasises the importance of transparent contract valuation and careful hedge market design in hybridised electricity markets.(This abstract was borrowed from another version of this item.)