Mandatory electricity contracts as competitive device

1
Mandatory electricity contracts as competitive
device

• ANNA CRETI
• LERNA and CEA
• University of Toulouse I

FEDERICA MANCA Autorità Garante della Concorrenza
e del Mercato
Conference on the Economics of Electricity
Markets, Toulouse 2-3 June, 2005
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Why Mandatory Contracts?

• To prevent the insurgence of strategic conducts
  and to control for excessive power prices
  regulators tend to promote
• the implementation of pro-competitive
  interventions (micro regulation of prices in the
  spot markets, measures to foster final consumers
  responsiveness to prices )
• introduction of bilateral trading to supplement
  spot markets
• However, from a theoretical view critics has been
  raised on the effectiveness of a contract market
  to mitigate market power in the electricity
  industry
• At the same, some forms of contractual regulation
  have been discussed or implemented in several
  countries

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Idea of the paper

• Our contribution to the debate is twofold
• provide a comprehensive screen on
  country-specific contractual regimes
• model contractual obligations as to mimic
  practical experiences and examine their potential
  as a competitive device
• We drive policy recommendations regarding the
  effectiveness of a contract market regulation to
  ensure competitive outcomes

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Contract market regulation

• Bilateral contracting accomplish several goals
• hedging against the risk of spot price
  volatility
• ensuring generation or supply adequacy as an
  alternative tool to promote entry (ex. auctions
  virtual capacity release) or to secure the system
  (capacity obligations ex. must run plants)
• Thus contractual obligations on capacity or on
  supply are not incompatible with a system of
  voluntary exchanges
• Mandatory contracts have been implemented in
  several deregulated industries the motivation
  and the implementation differ, still a power
  market mitigation intent can be detected

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Country-specific contractual practices

• Regulation can require generators to contract
• Successful upstream regulation experiences are
  given by England, Australia and Brazil that
  required incumbent generators to subscribe 3-5
  years contracts with distributors. Quantities and
  prices were subject to regulatory approval
• Ineffective upstream contractual regulation has
  been experienced in Alberta and New Zealand.
  Extensive usage of hedge contracts but among
  vertically integrated firms deterrence of entry
  downstream

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Country-specific contractual practices

• Regulation can require retailers to enter into
  long-term agreements
• Italy is the most significant example. The Single
  Buyer was imposed to auction supplying contracts
  with generators for no less than 30 of its total
  energy sales to non-eligible consumers
• Under the new Energy Law (2004), regulator in New
  Zealand have been given the power to mandate
  generators or retailers with minimum quantity
  agreements
• The EU Commission and the Californian regulator
  have both recommended suppliers to contract as a
  measure to secure supply adequacy

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Related Literature

• Green (2003) shows that the benefits of a
  contract market are weak when contract demand is
  not risk-neutral and retailers face increasing
  downstream rivalry
• risk-aversion reduces elasticity of demand
• downstream competition makes retailers reluctant
  to enter into long-term agreements, as they fears
  to be looked-in
• inefficient contracting emerges as an equilibrium
  and spot prices are far above the competitive
  level

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Greens game formulation

• Three stage game
• in the first stage, the contract market, Cournot
  generators choose their forward positions (x)
  under uncertainty
• in the second stage, the spot market, demand
  becomes known, and generators select quantities
  (q)
• the third stage solves for contract demand that
  is a negative function of the margin between the
  forward and the expected spot price
• Results are
• a contract market is not likely by it self to
  mitigate market power
• positive contracting emerges only for an expected
  spot price exceeding the forward price

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The Model mandatory measures

• We introduce a contractual obligation in Green to
  investigate the conditions under which this
  behavioral measure can be effective to restore a
  competitive equilibrium in the spot market
• The measure is such that agent is total
  contracting becomes
• mandatory contracts represent a constraint, while
  private ones are the strategic variable for
  hedging purpose
• at the decentralized equilibrium all contracts
  depend on the measure
• Two opposite effects on generators incentives to
  trade
• a pro-competitive effect
• a crowding-out effect, as mandatory contracts are
  strategic substitutes for private ones.

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The Model mandatory measures

• We study Nash solutions for six different
  regulatory designs that mirror country-specific
  experiences
• the measure is set horizontally on generators
  (upstream) or on retailers (downstream)
• for each of the above cases the measure further
  affect only one agent (asymmetric) or on all
  agents (symmetric)
• the measure can be vertical when it links one
  generator to a retailer or all generators to all
  retailers

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An example asymmetric upstream measure
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Comments on reaction functions

• The sensitivity of either firm i and j in terms
  of private contracts increases compared to the
  case of no measure
• the larger the share of public contract the
  flatter the reaction functions but an adverse
  quantitative effect of M shifts inwards both
  reaction functions
• The overall impact is stronger on firm i since
  the measure is asymmetric
• firm i is more aggressive in the contract market,
  relying on a given source of revenue,
• but is adversely affected by a larger
  crowding-out effect

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Optimal Policy

• For each scenario, but the vertical one, we can
  target the optimal measure that solves the
  inefficient contracting and retrieve a
  competitive outcome
• The optimal measure maximizes consumer surplus
  subject to generators break-even constraint
• a symmetric upstream measure crowds out both
  generators private contracting, while imposed
  asymmetrically it enhances only bilateral trade
  for those who are not mandate to contract
• downstream measures preserve forward exchanges
  for all generators, but only if structural
  conditions are satisfied
• Marginal cost pricing in the spot market allows
  to compute the amount of total (private and
  mandatory) contracts and to rank Nash solutions

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Ranking of Nash solutions
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Ranking of Nash solutions graphic
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Ranking of Nash solutions

• Results
• firms private contracting the upstream
  asymmetric measure grants the highest level
• total private contracting downstream measures
  induce all generators to engage in more bilateral
  contracting compared to the upstream regulation
• mandatory contracting the largest share of
  mandatory long-term agreements corresponds to the
  asymmetric upstream case in which there is the
  strongest crowding out effect
• private versus mandatory contracting downstream
  measures do not eliminate the crowding-out effect
  thus mandatory contracting is larger than the
  private one upstream asymmetric measure
  reintroduces a pervasive regulation on one
  generator

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Conclusions and Policy Implications

• Mandatory contracts imposed vertically do not
  solve the inefficient contracting problem
• the impact of the measure is perfectly
  anticipated by agents firms substitute away
  private contracting to exactly compensate the
  level of the mandatory ones
• Greens total amount of contracting is retrieved
• As for the others contractual regimes, the
  balance between pro-competitive and crowding-out
  effects has to be accounted for
• optimal upstream symmetric measure is not
  compatible with a private trade
• optimal upstream asymmetric measure comes at the
  cost of totally regulating one generator
• optimal downstream measures smooth risk-aversion
  but limits the size of private trade with respect
  to mandatory contracts.