1. Adaptation in Long Term Contracts: The Case of US Coal 1980-2000 Kanishka Kacker University of Maryland, Department of Agriculture and Resource Economics June 25 th 2010

2. Prelude: 2 quotes Joskow (1985): “Long-term (nominal) fixed-price contracts are simply not credible in a market like this, and I would not expect them to be used extensively” Hart (2009) Proposition 1: “(Price) Indexed contracts are strictly superior to nonindexed contracts” “(This) result is consistent with Joskow’s finding that price indexation is a common feature of contracts between suppliers and buyers of coal”

3. These assertions are contradicted Coal transportation rate database, Energy Information Administration, USA In 1980 the dominant contract form specifies a Base Price with escalation clauses built in … …In 2000, this is no longer true Fixed Price contracts account for approx 50% of contracts

4. Some good questions Are these buyers (Power Plants) and sellers (Coal Mines) being silly? – Herbert Simon (1951): “Human behaviour is intendedly rational, but only limitedly so” Who cares about coal anyway? – Wide variation in governance forms at a point in time (Joskow, 1987) – Environmental regulation  alters governance structure over time  underlying motivation

5. Supplier Side shifts (1) …production of Western Mines increases rapidly

6. Supplier Side Shifts (2) …while the number of mines declines overall, Appalachian/Interior mines fall by a greater amount… …so average mine size increases overall, but the increase for Western mines is massive

7. Demand side shifts 1990 Clean Air Act Amendment – Established permit trading program for Sulfur Di- Oxide – Total emissions capped – Constraint set to bind in 2 phases Phase I (begins 1995) targets the dirtiest 110 coal- burning power plants Phase II (begins 2000) new restrictions on cleaner plants, older restrictions tightened

8. Why have long term contracts at all? – Given significant investment in relationship-specific capital, repeated bargaining is unattractive – Hold-up problem: “Sunk” investments create opportunities for haggling ex-post Discourage investment ex-ante – These opportunities need to be mitigated to allow for (efficient) trade – A long term contract is the instrument through which this mitigation is carried out

9. What determines contractual relations? Williamson (1985): governance form varies according to – Asset Specificity – Uncertainty – Frequency

10. Joskow’s interpretation (1987) Contract duration = F (Site Specificity, Physical Asset specificity, Dedicated Assets) Site specificity = “Mine-mouth” Power Plants Physical asset specificity = Boiler specification for different kinds of coal Dedicated assets = Coal quantity Joskow interpretation: Williamson theory should predict F 1 >0, F 2 >0, F 3 inverse U shape This is what he finds

11. Joskow (1987) Contract duration = F (Site Specificity, Physical Asset specificity, Dedicated Assets) F 1 >0, F 2 >0, F 3 inverse U shape “Dedicated Assets” Physical Asset Specificity “Site Specificity”

12. Regulation, technology alteration and altered contracts Power plant engineers begin to alter boilers to burn Western coal Changing boiler technology  asset more generic  decreased physical asset specificity  lessens incentive to engage in long-term contracts

13. Revisit earlier model: Does the prediction of declining asset specificity hold up? Contract duration = F (Site Specificity, Physical Asset specificity, Dedicated Assets) Want a reduced coefficient for physical asset specificity… Will take data from 1990 to 2000, and divide into two time periods 1990 - 1995 and 1995 – 2000

14. Comparative Static Assessment Joskow: Mine

15. A comparative static assessment We have evidence of a buyer (power plants) looking to alter a technology to accommodate a changing supplier (coal mine) => Following transaction cost theory (Williamson 1985), physical specificity is reduced  less incentive to engage in long term contract The only assessment allowed by this theory is a comparative static one

16. How do contracts change as their environment changes? Why is this important? – Examine how contracts work, not “make or buy” – Klein (2004) talks about examining changes in contractual arrangements to changing circumstances – “Contracts as reference points” theory predictions flatly contradicted by data on coal contracts Most theorizing has taken a static viewpoint – Che and Sakovics (2004) explicitly talks about a dynamic theory of hold-up – Admitting dynamics, they find hold-up need not entail underinvestment Dynamics of contractual change need to be understood Through the effects of regulation on contractual arrangements

17. Summing up Dataset of contracts that capture buyer-seller interaction at a time when both experience significant shifts Evidence of altered contractual arrangements in line with a comparative static prediction of transaction cost theory Explicit characterization of dynamics underlying contractual shifts (following from regulation) is what is needed