The Costs of Counterparty Risk in Long-Term Contracts

Organised by

• Department of Economics

This paper studies buyers’ counterparty risk as a major market failure in long-term contracting, leading to inefficiently high prices, excessive risk, and under investment. This is especially relevant in sectors with capital-intensive, long-lived investments, and volatile spot prices, such as electricity markets, where it may undermine efforts to deploy renewable energy and hinder carbon-abatement goals. Eliminating counterparty risk using costly collateral may harm both buyers and sellers. Policy interventions aimed at boosting demand for long-term contracts, providing public guarantees, and allowing regulators to serve as counterparties, may be effective in as much as they tackle counterparty risk directly.