When Market Incompleteness Is Preferable to Market Power : Insights from Power Markets

Since the liberalization of power markets in Europe, almost all investments have required government subsidies. This demonstrates the failure of short-term markets to send the right price signals to investors, but other market failures have been brought to light, among which is market incompleteness. The literature has consistently shown the benefits of risk-sharing instruments to complete a market and boost investments in the absence of market power. Because of entry barriers and legacy assets, however, some producers today find themselves in a dominant position with the possibility of abusing the market. This paper investigates the impact of completing a market with financial contracts in the presence of market power. Starting from the benchmark case of a capacity-expansion problem in a perfectly competitive and complete market, we formulate a set of equilibrium stochastic models of risk-averse agents investing in a first stage and then operating and trading electricity in a short-term market with possibly two types of failure: incompleteness and market power. We provide existence results and conduct a thorough numerical application inspired by the French case. Contrary to what is reported in the literature, we highlight conditions under which social welfare is worse off when completing the market in the presence of a price-making incumbent. We also show that a strategic incumbent might reduce the volume of hedging contracts to induce physical scarcity. Finally, using the entropic risk measure, we provide a theoretical proof of this result in the case of a monopoly