Adaptation in Long Term Contracts: The Case of US Coal 1980-2000

Kanishka Kacker

University of Maryland, Department of Agriculture and Resource Economics

June 25th 2010

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”

These assertions are contradicted Coal transportation rate database, Energy Information

Administration, USAIn 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

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

Supplier Side shifts (1)

…production of Western Mines increases rapidly

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

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

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

What determines contractual relations?

• Williamson (1985): governance form varies according to

– Asset Specificity

– Uncertainty

– Frequency

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 F1>0, F2>0, F3 inverse U shape

This is what he finds

Joskow (1987)

Contract duration =

F (Site Specificity, Physical Asset specificity, Dedicated Assets)

F1>0,

F2>0,

F3 inverse U shape

“Dedicated Assets”

Physical Asset Specificity

“Site Specificity”

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

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

Comparative Static AssessmentJoskow: Mine

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

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

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