Forward Contracts, Auctions and Efficiency in Electricity Markets

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

2. 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

3. 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.

4. The basic model • Single-technology model with linear costs. • The per-unit operating cost is c, the per unit capacity cost is r, and krepresents the industry’s installed capacity. • Power generation, however, has an upper bound equal to θk, 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.

5. 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:

6. 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.

7. Oligopolistic equilibrium • Firm i’spayoff function is: • Reaction curve • Nash equilibrium with n symmetrical firms:

8. 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.

9. 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

10. 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:

11. 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:

12. 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.

13. 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 xa 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:

14. Period 1: Contractawarding • A long-term contract to supply xais 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.

15. Theoptimalauction • 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 θk*. • If x* > θk*, then the firm will have to purchase in the spot market an amount x* - θk*. Consumers will sell this amount if the price offered equals p(θk*). (ignoring income effects) • If x* < θk*, then firms will have to sell in the spot market the amount θk*-x*. Consumers will purchase this quantity if the price equals p(θk*).

16. 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.

17. Futurework • 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.