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

2. 2 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

3. 3 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

4. 4 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

5. 5 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

6. 6 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

7. 7 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

8. 8 Green’s 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

9. 9 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 i’s 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.

10. 10 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

11. 11 An example: asymmetric upstream measure xixi xjxj Rsj(xi)Rsj(xi) Rsi(xj)Rsi(xj) A e -c-m i M α A e -c-m i M β s A e -c-m j M β A e -c-m j M α s M mc MsMs MisMis x * i > 0 x * i > x * j x*i< x*jx*i< x*j x * i = 0 x*ix*i x*jx*j R s i (x * j ) = βsαβsα x*ix*i A e -c-m j M β R s j (x * i ) = αsβαsβ x*ix*i A e -c-m i M α

12. 12 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

13. 13 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

14. 14 Ranking of Nash solutions

15. 15 Ranking of Nash solutions – graphic xixi xjxj

16. 16 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

17. 17 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; –Green’s 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.