Pablo Serra Universidad de Chile Forward Contracts, Auctions and Efficiency in Electricity Markets

Introduction The purpose of this work is to derive an efficient market organization for the electricity industry. Stylized facts of Chilean economy Even if almost all consumption were traded in future/forward markets, a spot market would still be required for balancing short-term contingencies. The spot market, unless unregulated, is likely to be inefficient as generating companies would exert market power. Capacity is fixed in the short-run and no inventories are at hand The generation industry is not atomistic

Results Free entry, “efficient” regulation of the spot market and demand participation are concurrent conditions for an efficient market. If entry barriers limit the number of generators: Generators exert market power via their investment decisions. Long-term forward contracting reduces market power. Achieving the efficient equilibrium requires that demand be auctioned Market reform has not worked.

The basic model Single-technology model with linear costs. The per-unit operating cost is c, the per unit capacity cost is r, and k represents the industry’s installed capacity. Power generation, however, has an upper bound equal to θ k, where  is a random variable representing, for instance, hydrology with a distribution function dF(  ). Demand is given by q = a-p, where p denotes the price.

The basic model Efficient regulation: mandatory dispatch of units in merit order as long as the spot price exceeds the variable cost. Capacity is always fully used (conditions are in the paper). Thus the spot price equals: All parties are risk-neutral and have rational expectations The industry’s expected profits are given by:

Efficient solution Consumer surplus Social welfare Efficient solution Notice that π (k*)= 0. Hence free entry and perfect regulation of the spot market ensure efficiency.

Oligopolistic equilibrium Firm i’s payoff function is: Reaction curve Nash equilibrium with n symmetrical firms:

Long-term forward market Three-period static game (extends Allaz and Vila 1993 to consider stochastic supply) Period 1, firms offer forwards that atomistic speculators buy to resell in the spot market. Period 2, generators simultaneously commit their investments given existing forward contracts. Period 3, after uncertainty is solved, the dispatcher determines the spot price that balances supply and demand. Supply contracts are enforceable and observable. The game is solved by backwards induction.

Period 2: Capacity choices For simplicity, the discount rate is assumed to be zero. Then firm i’s value function is: The reaction function of firm i is: The Nash equilibrium quantities

Period 1: Forward market trading In period 1, firms simultaneously choose the amount of forwards they want to sell for delivery in period 3. Demand for forwards comes from competitive speculators making zero profits,  forward trading equals the producers’ offers. Denoting pf the forward price, the expected profits of firm i are given by:

The Nash equilibrium Rational expectations and risk neutrality by speculators imply that the forward price equals the expected spot market price, thus: Hence Thus the game Nash equilibrium quantities are:

Long-term auctions Mass of consumers coordinate themselves to auction a long- term supply contract before investments are committed. The entire forward contract is awarded to the firm that bids the lowest price. In the spot market purchase consumers who do not contract energy in advance, and generators and contracted consumers trade energy. In the first period a contract to supply a given quantity in the spot market is auctioned, and in the second period, the producers decide on their capacities. The game is solved by backwards induction.

Period 2: Capacity choices Firms simultaneously choose their capacity depending on the outcome of the auction. Let 1 be the firm that won the contract in period 1 and x a the quantity auctioned. Then, its expected spot market profits are given by The value function for other firms is simply Thus the second-period equilibrium quantities are:

Period 1: Contract awarding A long-term contract to supply xa is awarded in a competitive bid. Profits of the award-winning firm are: Profits of other firms are given by: All firms have equal profits in the Nash equilibrium of the game, hence The auction price equals the expected efficient price. The auction also reduces the spot price.

The optimal auction In order to achieve the welfare maximizing capacity k*, the supply auctioned has to equal: The implementation of such contract raises practical questions. Consumers contract a supply x*, but available supply equals θ k*. If x* > θ k*, then the firm will have to purchase in the spot market an amount x* - θ k*. Consumers will sell this amount if the price offered equals p( θ k*). (ignoring income effects) If x* < θ k*, then firms will have to sell in the spot market the amount θ k*-x*. Consumers will purchase this quantity if the price equals p( θ k*).

Crucial efficiency condition Long-term contracts: generators determine their investment after contracts are awarded. Implicit assumption: bidding is costless and generation costs are known (price index is chosen by the bidder). But obtaining environmental permits is time and resource consuming and uncertain. Generation costs depend on environmental requirements.

Future work Firms participating in contract markets take into consideration theirs and their rivals project with approved environmental studies. Moreover, permit applications could be used by generators to tacitly collude in the contract market. Future work should extend modeling in this direction; otherwise, any policy recommendation would be flawed.