withholding investments in energy only markets

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

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

2

Objectives

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)

3

Energy only market

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.

4

Contracts market

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.

5


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 Allaz–Vila 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.

6


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.

7

Discussion

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)

8

Theoretical model

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=αs- 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

9

Theoretical model 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.

10


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 player’s 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

11


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 Allaz–Vila model depends on

capacity not binding.

12

Theoretical model 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 Allaz–Vila behavior back to a Cournot behavior

production does not increase when at least one capacity constraint is

binding.

13

No impact of contracts when the pattern of

binding capacity is unchanged 14

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

πs – 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.

15

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 Allaz–Vila

forward market game would be


binding capacity is unchanged

16

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 closed-

loop game.



17

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.



18

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 19

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 Allaz–Vila quantities as

long as capacity is not binding.

When forward markets increase capacity

If the generation for player 2 increases beyond capacity with contracts

while the generation of 1 remains below capacity, then

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.

20

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.


binding capacity is changed

21

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 Allaz–Vila effect with contracts increasing production.

If the Allaz–Vila solution exceeds the capacity of both players,

only one player generates at capacity

there are multiple equilibria in the contract market

both increase capacity.



22

When forward markets reduce capacity

If the Allaz–Vila 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 Allaz–Vila 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.



23

The discontinuity in the response of player 1 is because the contracts

equilibrium condition for player 1 changes from the Allaz–Vila condition to

the Cournot condition discrete increase in the price for this time segment

and a jump in player 2’s profit.

Interior solution – no capacity binding; Corner solution – capacity binding

At the only profit function is the one associated with the

corner equilibrium.




24

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 Allaz–Vila

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.


25

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

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.

26

Conclusion 27

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.

Thank you!

28

withholding investments in energy only markets

Documents