1. on the use of swaps in electricity markets
Chloé Le Coq Sebastian Schwenen Stockholm School of Economics (SITE) Technical University of Munich
The game known as "Battle of Sexes" (Luce and Raiffa, 1957) is the simplest game with two pure strategy equilibria. A different pure strategy equilibrium is preferred by each player.
IAEE 2017 Singapore June 2017

2. Hedging in the electricity market
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Hedging in the electricity market
Electricity prices in the spot market are highly variable.
price fluctuations potentially expose all market participants
Two parties can agree to a hedging contract that will effectively set the price in advance : e.g. Generator and retailer

3. Different hedging products
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Different hedging products
in practice, different ways to bear the risk …
different hedging products
exotic contracts : Weather contingent options, Asian options, Swaptions, Outage protection contracts, Load following contracts, Price Floors…
a flat cap: a contract that gives the holder the option to buy a given amount of electricity at an agreed price.
a base load swap: a contract to trade a fixed amount of electricity for a certain price

4. Focus: Swaps signed in NY Spot Capacity Market
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Focus: Swaps signed in NY Spot Capacity Market
Keyspan (a pivotal supplier of capacity) signed a Swap contract with Morgan Stanley for 3 years ( )
If market price above $7.57, Morgan Stanley pays Keyspan the difference to the market price. This difference was due for a quantity of 1800 MW.
If market price below $7.57, Keyspan pays this difference to Morgan Stanley
Astoria (and the largest competitor) signed (opposite) Swap contract with Morgan Stanley for 3 years ( )
If market price above $7.07, Astoria pays to Morgan Stanley the difference to the market price, also applied on 1800 MW.
If market price below $7.07, Morgan Stanley pays to Astoria receives this difference from Morgan Stanley
NB : The difference in the strike price of $0.5 was Morgan Stanley’s margin

5. Focus: Swaps signed in NY Spot Capacity Market (BIS)
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Focus: Swaps signed in NY Spot Capacity Market (BIS)
Why signing such contracts ?
KeySpan can unilaterally set the capacity price at its bid cap (pivotal power)
=> incentive for KeySpan to get the higher price not only for its dispatched units, but also the capacity included in the swap.
Morgan Stanley balances her position by signing a swap with Astoria.
Astoria (seems to) believe that, absent the swap, the expected spot price would be somewhere in the neighborhood of $7.57/kW- month.

6. Research Question P. Cramton’s statement to the FERC in 2007
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Research Question
P. Cramton’s statement to the FERC in 2007
“The KeySpan-Morgan Stanley swap appears to be a financial instrument specifically negotiated to strengthen the incentive for, and the likelihood of, the exercise of market power by KeySpan“
Our research question: Can such financial scheme be used to increase market power on the spot market?

7. The auction setup without SWAP
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The auction setup without SWAP
Model based on Fabra, Harbord and von der Fehr (2006)
Firms 1 and 2 have capacities k1 and k2 and compete in a uniform-price auction

8. The auction setup without SWAP
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The auction setup without SWAP
Model based on Fabra, Harbord and von der Fehr (2006)
Firms 1 and 2 have capacities k1 and k2 and compete in a uniform-price auction
Optimal strategy for firm 1 given firm 2, where k1 + k2 > D and k1 >D- k2 ? D P* b2
Let consider only two firms 1 and 2 and assume that firm 1 offers all its units at at certain bid b1 and b2
Replicate the electricity market design
Firms compete in each period by submitting supply functions for their available capacity (one price is submitted for each unit).
Regulator (computer) collects bids and determines the uniform market price which is the marginal bid that satisfies the demand.
If several players tie for the lowest price, one of them is randomly selected to earn the monopoly payoff at the lowest price
Each round consists of blabla
Quantity k2 k1

9. The auction setup without SWAP
6/26/2018
The auction setup without SWAP
Optimal strategy for firm 1 given firm 2, where k1 + k2 > D and k1 >D- k2 ?
Undercutting b2 D P*
Let consider only two firms 1 and 2 and assume that firm 1 offers all its units at at certain bid b1 and b2
Replicate the electricity market design
Firms compete in each period by submitting supply functions for their available capacity (one price is submitted for each unit).
Regulator (computer) collects bids and determines the uniform market price which is the marginal bid that satisfies the demand.
If several players tie for the lowest price, one of them is randomly selected to earn the monopoly payoff at the lowest price
Each round consists of blabla b2 b1
Quantity k2 k1

10. 6/26/2018
Optimal strategy for firm 1 given firm 2, where k1 + k2 > D and k1 >D- k2 ?
Undercutting b2 and providing all its units D P* b2
1. Supply. There are 4 firms (subjects) in a market. Each firm has a production capacity of 9 units. The costs depend on the capacity choice, as well as the number of units sold. There is a fixed cost of 7 per unit of capacity. Moreover, there is a simple marginal cost scheme: the first unit costs 1, the second costs 2...
Note that the generation cost is a crucial variable in this design. Since production cost increases very quickly with additional units, the incentive to hold high capacity levels is very low, and therefore there is a positive probability of having power cuts when demand is high.
2. Demand. The demand is stochastic, but the probability distribution is not symmetric. The experiment consists of 10 rounds of 6 periods. In each round, there are four first periods with low demand (7 or 8 or 9 units with equal probability), and two last periods with high demand (23 or 24 or 25 units with equal probability). Subjects are aware of the exact level of the demand at the beginning of each period.
Uniform price auction:
Let consider only two firms 1 and 2 and assume that firm 1 offers all its units at at certain bid b1 and b2
Replicate the electricity market design
Firms compete in each period by submitting supply functions for their available capacity (one price is submitted for each unit).
Regulator (computer) collects bids and determines the uniform market price which is the marginal bid that satisfies the demand.
If several players tie for the lowest price, one of them is randomly selected to earn the monopoly payoff at the lowest price
Each round consists of blabla b1
Firm 1’s Profit
Quantity k1 k2

11. 6/26/2018
Optimal strategy for firm 1 given firm 2, where k1 + k2 > D and k1 >D- k2 ?
Setting b1=P* and getting the residual demand D
b1 = P*
Firm 1’s Profit*
1. Supply. There are 4 firms (subjects) in a market. Each firm has a production capacity of 9 units. The costs depend on the capacity choice, as well as the number of units sold. There is a fixed cost of 7 per unit of capacity. Moreover, there is a simple marginal cost scheme: the first unit costs 1, the second costs 2...
Note that the generation cost is a crucial variable in this design. Since production cost increases very quickly with additional units, the incentive to hold high capacity levels is very low, and therefore there is a positive probability of having power cuts when demand is high.
2. Demand. The demand is stochastic, but the probability distribution is not symmetric. The experiment consists of 10 rounds of 6 periods. In each round, there are four first periods with low demand (7 or 8 or 9 units with equal probability), and two last periods with high demand (23 or 24 or 25 units with equal probability). Subjects are aware of the exact level of the demand at the beginning of each period.
Uniform price auction:
Let consider only two firms 1 and 2 and assume that firm 1 offers all its units at at certain bid b1 and b2
Replicate the electricity market design
Firms compete in each period by submitting supply functions for their available capacity (one price is submitted for each unit).
Regulator (computer) collects bids and determines the uniform market price which is the marginal bid that satisfies the demand.
If several players tie for the lowest price, one of them is randomly selected to earn the monopoly payoff at the lowest price
Each round consists of blabla b2
Quantity k2 k1

12. Comparison between profits depends on firms j’s bidding price
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Comparison between profits depends on firms j’s bidding price
Limit price: sufficiently low price to make undercutting unprofitable for firm 1
PL =function (P*,D,k2 ,k1) and firm 2 sets b2 s.t. b2≤ PL D P*
Firm 1’s profit
b2=PL 1.
Uniform price auction:
Let consider only two firms 1 and 2 and assume that firm 1 offers all its units at at certain bid b1 and b2
Replicate the electricity market design
Firms compete in each period by submitting supply functions for their available capacity (one price is submitted for each unit).
Regulator (computer) collects bids and determines the uniform market price which is the marginal bid that satisfies the demand.
If several players tie for the lowest price, one of them is randomly selected to earn the monopoly payoff at the lowest price
Each round consists of blabla
Firm 1’s Profit
Quantity

13. The auction setup with SWAP
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The auction setup with SWAP
Same logic but firms have signed a swap as in NY market,
Firm 1 (KeySpan) has a pivotal power (can unilaterally set the capacity price at its bid cap) and has a significant market share => always pivotal bidder
Firm 2 (Astoria) has an “opposite” swap and will transfer some capacity to KeySpan as soon as the spot price is above the market => always inframarginal bidder
Let consider only two firms 1 and 2 and assume that firm 1 offers all its units at at certain bid b1 and b2
Replicate the electricity market design
Firms compete in each period by submitting supply functions for their available capacity (one price is submitted for each unit).
Regulator (computer) collects bids and determines the uniform market price which is the marginal bid that satisfies the demand.
If several players tie for the lowest price, one of them is randomly selected to earn the monopoly payoff at the lowest price
Each round consists of blabla

14. Three main results (with D= a-dp)
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Three main results (with D= a-dp)
Result 1: If k2 < D(0) < k1 or max{k1 , k2 } < D(0) and k1 + k2 > D(b1* | b1* > b2*), firms can sign a contract that increases both players’ profits if the price cap is non-binding before the contract.
intuition:
(i) high bidder is willing to offer a higher bid (hence higher market price) since she gets the higher price not only for its dispatched units, but also the capacity included in the swap
(ii) low bidder is also benefiting from this increase since market price per se increases
Result 2: If price cap is binding, this “double” financial agreement cannot take place as it is not beneficial for the low bidder.
intuition: no increased market price so low-bidder is not benefiting from the swaps.
Result 3: If firms become more symmetric (i.e. role of high bidder not obvious ), such double financial agreement can help firms to coordinate to maximize their profits
=> intuition: swap can act as a commitment device for the low bidder, working as a side-payment for ________the high bidder.
Let consider only two firms 1 and 2 and assume that firm 1 offers all its units at at certain bid b1 and b2
Replicate the electricity market design
Firms compete in each period by submitting supply functions for their available capacity (one price is submitted for each unit).
Regulator (computer) collects bids and determines the uniform market price which is the marginal bid that satisfies the demand.
If several players tie for the lowest price, one of them is randomly selected to earn the monopoly payoff at the lowest price
Each round consists of blabla

15. 6/26/2018
Conclusion
Results (summary): the anti-competitive effect of swap contracts like the ones signed in NY market depends on the market structure (D, K, price cap)
Contribution:
Add to the empirical literature on market power in the electricity market (e.g. Puller and Hortacu (2008) or Schwenen (2015))
Different financial agreement considered by former IO literature on the interaction between forward and spot market (Allaz and Vila (1993), Liski and Montero (2006), or Green and Le Coq (2010)…)
First paper (to our knowledge) looking at the impact of swap contract when actors are taking “opposite” position (but well-known results in IO literature on side-payments!)
Next steps look at the NY market data

16. Thank You