Derisking Electricity Prices For Decarbonisation

Decarbonising European industry requires significant electrification, yet long-term electricity contracting – particularly through Power Purchase Agreements (PPAs) – has failed to take off at scale. While policy makers imagined PPAs as a key tool to reduce risk and encourage investment in both clean electricity and electrified industrial processes, historical data shows that this expectation may be misplaced. In this paper, we bring new theoretical backing to the initially unexpected lack of contracting, by highlighting the intricate relationship between risk and ambiguity in these infrastructure-heavy settings – and show that the irreversible nature of such contract can hinder their signature. To achieve this, we build a bilateral contracting model mimicking contract negotiations between two agents faced with irreversible investment decisions. By addressing these issues, we bridge a literature gap by linking research on industrial decarbonisation, electricity market incompleteness, and risk management. Our bilateral contracting model contributes to several strands of research. It offers a new perspective on market incompleteness for infrastructure-heavy sectors. We then extend the theoretical insights with real-world calibrations, allowing us to determine whether the risk aversion or irreversibility effect dominate in electricity markets. Our findings suggest that high market volatility amplifies the irreversibility premium and the associated opportunity costs of entering contracts, thereby outweighing the effects of ambiguity aversion. Through these results, we also contribute to the literatures exploring electricity market incompleteness as well as industrial decarbonisation under uncertainty - at times where risk and ambiguity are considered as the main barriers preventing rapid decarbonisation investments in these sectors.