WITHHOLDING INVESTMENTS IN ENERGY ONLY MARKETS: CAN CONTRACTS MAKE A DIFFERENCE?

FREDERIC MURPHY, YVES SMEERS (2012) Seminar International Energy Management

18.01.2013

Taissia Galperina

Agenda
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Objectives Energy only market Contract market Models used in the research Theoretical model Impact of contracts on capacity levels Finding an equilibrium in the capacity game

Objectives
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Withholding investments can increase profits and hamper adequate capacity expansion. The effect on investment of one suggested approach to reducing market power, contracting longer term, have been examined. Three-stage model of an energy-only market where two firms: Invest in the first stage (forward position) Contract part of their production in the second stage sell the rest in the third stage (spot market)

Energy only market

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The missing money problem arises when occasional market price increases are limited by administrative actions (price caps).
Reduced incentives to maintain plant or build new generation facilities. Solution: energy only markets

Incentives in energy only market appear through the voluntary interactions

No administrative price caps or other interventions Pays resources only for the energy and ancillary services they deliver, not for ICAP. Approach presumes that spot prices can be made to reflect operating conditions and to provide the right incentives. Includes appropriate market structures and incentives for generators to invest up to competitive levels.

Contracts market
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Market power can be expected to add to other concerns that reduce the incentive to invest, such as the missing money problem, long run uncertainties, or the volatility of peak rents One of the market structures offered to contribute to mitigating market power is a contracts market. Examining the question: Impact of contracts in an energy only market affected by market power. Research question 1: whether contracts can induce additional incentives to invest in an energy-only market Research question 2: whether a contracts market would further increase capacities when the equilibrium exists.

Models used in the research

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Research question 1: whether contracts can induce additional incentives to invest in an energy-only market: Allaz and Vila (1993) developed a two-stage game: Cournot players take positions in the forward market in the first stage and act on the spot market in the second stage. Adding a capacity game to the AllazVila model and observing the consequences of the added stage to the game. Murphy and Smeers (2005): offer a treatment of investments in a restructured energy-only market complemented by a contracts market and affected by market power.

Models used in the research

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Research question 2: whether a contracts market would further increase capacities when the equilibrium exists. extend the original model by inserting a third contracts market between the investment and spot-market stages analyze whether energy contracts can help incentivize investments Closed-loop approach comparing the results from the Murphy and Smeers model with those obtained by including a third stage in the game where contracts are signed between the capacity and the spot-market games.

Closed loop game subgame perfection where players can observe and respond to their opponents actions at the end of each period. All past play is a common knowledge at the beginning of each stage.

Discussion
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An energy-only market can provide the appropriate incentive to invest when there is no market power and risk premia are sufficiently small.
Contradicting the common wisdom that: market power is a feature of electricity markets contracts can mitigate this power providing the incentive to invest. Capacity constraints on spot generation neutralize the ability of contracts to mitigate market power the incentives lead to investment below competitive levels The energy-only market is vulnerable to the exercise of market power when it comes to investments. Additional rules and market mechanisms need to be put in place to mitigate the market power (regulated contracts)

Theoretical model
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Two technologies each operated by different generator Market power assumed by Cournot competition- subgame perfect equilibria Each operator invests in the first stage, contracts a portion of capacity in the second stage and operates in the third stage. Let the inverse demand function be ps=s- qs, s= 1....,S in each time segment of the load curve. i=1,2 - technology ki - investment cost vi - operating cost with player i specializing in technology i. xi , i=1,2 capacity decisions y is , i=1,2 contractual positions z is , i=1,2 actual generation

Theoretical model
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Allaz-Vila when capacities are not binding

Then the spot-market equilibrium (optimization) for each player in the classic Cournot game without contract position is

Cournot conditions are: There is an adjustment by player 2 equal to half of the change by player 1. When optimizing its decisions, each player presumes there is no response by the other Each player sees the change in the action of the other player and responds by adjusting its quantity again while still presuming no response to its adjustment.

Theoretical model
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Allaz-Vila when capacities are not binding

Forward market: adjustment in the spot market of player 2 to the actions of 1. Each player responds to a change in production by the other player in the spot market knows the other players response in the spot market to its planned adjustment in its forward position. The spot equilibrium given the contract position ys= y1s, y2s

In the forward-market game each player sees the reaction of the other player but not the function in the forward game. Each player seeing that an increase in its generation in the spot marketinduced by increased forward position other player decreases generation in the spot game increased generation

Theoretical model
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Allaz-Vila when capacities are not binding

The perceived behavior of player 2 in the forward game and spot equilibriumplayer 1 sells in forward markets (y1 > 0) as a way to induce higher production in the spot game.
Allaz-Vilas equilibrium condition:

The effect of introducing contracts, ignoring the capacity constraints, is that the coefficient 2 in the Cournot conditions and becomes 3/2, the marginal profit is higher, the total quantity produced increases.
The increase in production in the standard AllazVila model depends on capacity not binding.

Theoretical model
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Allaz-Vila when capacities are binding

Let capacity bind for player 2 with the Lagrange multiplier on the capacity constraint in the spot market greater than 0 player 2 does not respond in the spot market to marginal changes in 1st player production decisions in the spot market: The optimization of the forward position of player 1:

Player 1 sees that player 2 cannot respond to a change in the contracts game equilibrium condition reverts to the classic Cournot condition. Adding contracts with fixed capacities that bind changes

the AllazVila behavior back to a Cournot behavior

production does not increase when at least one capacity constraint is binding.

No impact of contracts when the pattern of binding capacity is unchanged

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Contracts do not change capacity levels when the pattern of binding and non-binding constraints over the time segment s is the same with and without contracts.
ys (x)- equilibrium contract levels given x

s fraction of the year load step s applies

The capacity game with contracts is as follows:

The capacity game without contracts is this game with ys (x) = 0. (Slide 18)
A necessary optimality condition for each player is

The right hand side of this expression determines the marginal value of capacity.

No impact of contracts when the pattern of binding capacity is unchanged

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No impact of contracts on the capacity level if both players are at capacity in the spot market
If marginal value of another unit of capacity in time segment s with binding capacity, then

The marginal value of capacity in the game with a forward market is determined by the same marginal condition as the classic Cournot equilibrium that prevails in the game without the forward market.
No impact of contracts on the capacity level if one players is at capacity in the spot market. If player 2 at capacity and player 1 below capacity in time segment s, then

Marginal valuation of the capacity in time segment s of the AllazVila forward market game would be

No impact of contracts when the pattern of binding capacity is unchanged

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The marginal value of capacity is the same with and without forward markets
When the pattern of binding and non-binding time segments is identical for both players Contracts have no impact on the marginal value of capacity in the closedloop game.

No impact of contracts when the pattern of binding capacity is unchanged

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Foreclosure in forward markets: when player 2 is at capacity, the optimal contracts position of player 1 is = 0 (profit is maximized)
The profit as a function of is:

Profit for player 1 is also maximized when player 1 is foreclosed from forward markets.

Result implies that production in time segments with one player at capacity is the same with and without contracts.

No impact of contracts when the pattern of binding capacity is unchanged

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Differences between solutions to the two models in the capacity game can arise only when the time segments in which players are at capacity are different.
Changing the value of capacity changes the investment levels because the sum of the values of capacity over the time segments has to equal the cost of capacity. In Table 1: 0 in the table when capacity is not binding because a change in capacity does not change production in the spot market or total profits.

The reaction of player 2 to the action of 1 in the spot game.

The results apply to both players with and without forward markets

Impact of contracts when the pattern of binding capacity is changed

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Two time segments, peak and base, s = p,b

Without contracts assume both players are below capacity in base. Introducing contracts increases generation to the AllazVila quantities as long as capacity is not binding. If the generation for player 2 increases beyond capacity with contracts while the generation of 1 remains below capacity, then

When forward markets increase capacity

an equilibrium exists in the forward market where player 2 is at capacity while player 1 remains below capacity because player 2 increases production and = 0.

Impact of contracts when the pattern of binding capacity is changed

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Player 2 is generating at capacity in the base period The marginal value of capacity in the base time segment goes from 0 to positive for player 2 The sum of the marginal values for both time segments becomes greater than the cost of capacity for player 2 and he has an incentive to increase capacity. The reaction of player 1 to an increase in capacity by 2 has the slope 1/2 and total capacity increases.

Impact of contracts when the pattern of binding capacity is changed

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An increase in capacity by player 2 leads to a net increase in capacity.

Starting with the capacities in the game with no forward markets there is an optimality condition for player 2 to increase capacity and total capacity production.

This is the expected AllazVila effect with contracts increasing production.

If the AllazVila solution exceeds the capacity of both players, only one player generates at capacity there are multiple equilibria in the contract market both increase capacity.

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Impact of contracts when the pattern of binding capacity is changed

When forward markets reduce capacity

If the AllazVila equilibrium in base load is below the capacity of player 2 this player may have an incentive to reduce its capacity (capacity bind with production)

Binding capacity for player 2 to an equilibrium in the forward market where player 1 is foreclosed from the contracts market.
From the spot market equilibrium condition player 1 drops its production below the level in the AllazVila equilibrium. Reducing capacity for player 2 would not be profitable The equilibrium in the contract market then requires that player 1 drops its production by a discrete amount.

Impact of contracts when the pattern of binding capacity is changed

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The discontinuity in the response of player 1 is because the contracts equilibrium condition for player 1 changes from the AllazVila condition to the Cournot condition discrete increase in the price for this time segment and a jump in player 2s profit. Interior solution no capacity binding; Corner solution capacity binding
At the only profit function is the one associated with the corner equilibrium.

Finding an equilibrium in the capacity game

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Case 1: low off peak demand: the contracts market leaves capacity unchanged The capacity constraint is binding only in the peak time segment with a contracts market, The capacity level is unchanged with the addition of this market The production in the off-peak segment increases as in AllazVila Contracts have no effect on investments, they do not foreclose markets They mitigate market power in off peak but have no effect in the peak period, the time when prices are highest Case 2: medium base demand: the contracts market increases capacity Higher intercept increases total production in the base time segment. If no capacity limit player 1 would produce beyond the capacity limit. No interior solution and adding contracts leads to a corner solution Even though player 2 is excluded from the contracts market, total capacity and production in both load steps increase.

Finding an equilibrium in the capacity game

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Case 3: slightly higher base demand: multiple corner solutions leads to two corner equilibria in the contracts game each of the players can move to capacity in the base load step and foreclose the contracts market Case 4: the contracts market increases capacity with the corner equilibrium (However, there is also an interior equilibrium) Capacity increases with the corner equilibrium. At that capacity player 1 cannot guarantee the corner equilibrium. If total capacity decreases, the profits for player 1 are higher than with the interior equilibrium but lower than they would be if player 1 could enforce the corner equilibrium with the interior capacities.

Conclusion
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The energy-only market is vulnerable to the exercise of market power when it comes to investments.
Additional rules and market mechanisms need to be put in place to the mitigate the market power that results from under-investment in capacity (regulated contracts). Contracts ameliorate market power and increase production. Contracts have essentially no effect in periods of high demand when capacity constrains production. The effect of contracts is mainly felt during periods of low demand, where observation indicates that firms do not exercise substantial market power.

Conclusion
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If contracts lead to production beyond capacity when the capacity constraints are ignored, the foreclosure effect increases the incentive to invest and hence mitigates market power.
If adding contracts leads to production just below the capacities without contracts in some time segments, it can be profitable to reduce investments and increase market power. More direct interventions to ensure enough capacity are probably needed. For example, capacity markets with a well-specified capacity target provide sufficient capacity to ensure greater competition in the energy market.

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Thank you!