Bert Willems Cournot Competition, Financial Option Markets and Efficiency

Bert Willems Long Term Contracts? l Historically: Regulators opposed long term contracts  Entry might be slowed down  Decrease liquidity and transparency of the spot market l Currently: Regulators more in favor of long run contracts  Reduce market power (Bushnell et al.)  Allow Hedging (Bankruptcy California)  Security of supply issues / New Entry l Policy Question:  Regulation of amount of contracts signed?  Type of contracts?  Options – Futures // Financial – Physical contracts?  Virtual power plants / Capacity payments

Bert Willems This paper l Strategic effect of financial call options l Generators freely decide about number of option contracts they sell l 1 Option with 1 strike price (endogenous in model) l NOT  Hedging issues  Entry decisions  Security of supply issues  Regulation = obligation to buy/sell contracts

Bert Willems Paper = Extension of A&V l Allaz and Villa (1993)  Strategic reasons to sell Futures contract = commitment to produce more in spot market  Prisoners dilemma: markets become more efficient l My paper  Replace Futures with Call Option l Results of A&V – my paper rely on  Cournot competition (Mahenc and Salanie, 2004)  Observability of the futures position (Hughes and Kao)  Perfect inter-temporal arbitrage

Bert Willems Why Options? l Why look at options?  Hedge quantity risks  Retailers can counter market power of generators in peak period  Incomplete markets  solved by options l Two types  Physical options  a plant is assigned to the option contract  production decision is delegated to market  Financial option  monetary transfer  production decision stays with firm

Bert Willems Comparison with C&W (2004) CHAO & WILSON Oblige generators to sell physical call options l Perfect regulation of options sold l Entry in the contracting stage l Bundle of options one option of each strike price l Linear supply functions l Physical options  Allowing for entry and imposing optimal regulation voids any comparison of contract types  Non-standard assumptions on  option types  type of competition DISCLAIMER: My interpretation of earlier work !

Bert Willems Solution CHAO & WILSON Oblige generators to sell physical call options l Perfect regulation of options sold l Entry in the contracting stage l Bundle of options one option of each strike price l Linear supply functions l Physical options THIS PAPER l Quantity is endogenous l Number of generators is fixed l One option one pre-specified strike price l Cournot competition l Financial options  comparison with A&V

Bert Willems Two Stage Game Contracting Stage Production Stage Generators sell k i LT-contract at a price F Generators learn each other’s contracting position Generators sell q i electricity on spot market Generators payout insurance TIME Pay Off with Perfect arbitrage Financial call option = Insurance contract for prices above strike price S Payment Futures contract = Mutual Insurance against deviations of the futures price F Payment Reduced Pay Off with

Bert Willems Second Stage l Effect of ownership of futures  More aggressive behavior of generator  Own reaction functions shifts out l P > S: option in the money  same reaction function as with Futures l P< S: option is out the money  same reaction function as standard Cournot l P=S: Several Equilibria in 2 nd stage if a lot of options are sold Futures Contracts for Firm 1Option Contracts for Firm 1

Bert Willems First Stage l Futures  increases number of futures  Market share increases  Spot price goes down  Prisoner’s Dilemma: sell forwards l Options  Multiple Nash equilibria in second stage  No obvious focal point  Punishment equilibria possible  Assumption: generators co-ordinate on equilibrium highest price  Low price: generators sell a lot of options in the first stage Risky, assumes perfect co-ordination in the N.E.  High price: Lower profit in general with higher prices

Bert Willems Conclusions l Financial Call options increase market efficiency l Comparison with futures contracts  Depends on strike price  High Strike price (A)  Futures are better  Low Strike price (B)  Futures = Option  Intermediate prices (C)  Futures are better l Equilibrium Selection is important

Bert Willems Extensions l Physical options vs. Financial options  Two different types of property rights  Prisoner’s dilemma with Physical options is not there  See Working Paper l Other types of Financial insurance contracts  Insurance contracts which pay relatively more when prices are high: more competitive market  Work in progress

Bert Willems Future Work: Investments + Entry l LT-contracts + Entry  Lower risk (risk aversion)  Retailer and entrant (partially) internalize reduction of market power l Role of options?  Better hedging of quantity risks l NEEDED:  Extend model with uncertainty – risk aversion

Bert Willems Future Work: Regulation l Under-contracting by retailers  W.r.t. market power mitigation and reliability  Reason: missing markets  Contracting is public good l Regulation of long term contracts?  Should retailers / producers be obliged to buy/sell? l Role of options  Options might be cheaper regulatory instruments  Only put constraints on markets when there is a problem  Market conform l NEEDED  Model for market imperfection  missing markets (Explaining under-contracting by private players)  market power  Model for regulation costs  Asymmetric information?  Incomplete contracting?  Regulatory efficiency