Market Structure, Risk Preferences, and Forward Contracting Incentives

We examine the determinants of the levels of forward contracting preferred by generators and buyers of electricity. Increased forward contracting systematically reduces the variance of a generator's profit, so a generator prefers higher levels of forward contracting as market uncertainty or its aversion to risk increases. In contrast, increased forward contracting can either increase or reduce the variance of a buyer's profit. Consequently, a buyer can prefer either reduced or increased levels of forward contracting as market uncertainty or its aversion to risk increases.