retail competition and electricity contracts richard green university of hull and cepr

Retail Competition and Electricity Contracts

Richard Green

University of Hull and CEPR

The issue

• Retail competition is spreading– UK since 1999– Nordic countries since mid-1990s– some US states– EU draft directive

• Does this reduce suppliers’ incentive to contract?

• Would that affect electricity prices?

The model

• Two generators

• Regional incumbent retailers

• Non-strategic customers & entrant retailers

• Stage 1: long-term contracts

• Stage 2: annual wholesale market

• Stage 3: retail market

The annual wholesale market

£/MWh

MWh

Marginal Cost

Industry Demand

Profit

Rival’sSales

The annual wholesale market

£/MWh

MWh

Marginal Cost

Industry Demand

Profit

Rival’sSales

The annual wholesale market

£/MWh

MWh

Marginal Cost

Industry Demand

Profit

Rival’sSales

The annual wholesale market

£/MWh

MWh

Marginal Cost

Industry Demand

Rival’sSales Forward

Sales

The annual wholesale market

£/MWh

MWh

Marginal Cost

Industry Demand

Rival’sSales Forward

Sales

The annual wholesale market

£/MWh

MWh

Marginal Cost

Industry Demand

Profit

Rival’sSales Forward

Sales

The annual wholesale market

£/MWh

MWh

Marginal Cost

Industry Demand

Profit

Rival’sSales Forward

Sales

The annual wholesale market

£/MWh

MWh

Marginal Cost

Industry Demand

Profit

Rival’sSales Forward

Sales

The annual wholesale market

£/MWh

MWh

Marginal Cost

Industry Demand

Rival’sSales

Profit

ForwardSales

The annual wholesale market

£/MWh

MWh

Marginal Cost

Industry Demand

Rival’sSales

Profit

ForwardSales

The annual wholesale market

£/MWh

MWh

Marginal Cost

Industry Demand

Rival’sSales

Profit

ForwardSales

Forward sales depend upon

• Rival’s forward sales (ve)

• Forward annual price premium (+ve)

• Impact of extra sales on this premium (ve)

The retail market(s)

£/MWh

MWh

Industry Demand

Small customers

Large customers

The retail market(s)

£/MWh

MWh

Industry Demand

Small customers

Large customers

Annual wholesale price

Regulated incumbents

£/MWh

MWh

Industry Demand

Small customers

Large customers

Annual wholesale price

Regulatedprice

Regulated incumbents

Profits

Annualprice

Forwardprice

Average cover

Regulated incumbents

Profits

Annualprice

Forwardprice

Average cover

More cover

Regulated incumbents

Profits

Annualprice

Forwardprice

Average cover

More cover

Less cover

The regulated firm

• Likes profits

• Dislikes risk

- Utility = mean (profits) ½ variance (profits)

• Tends to buy the average level of cover

• Would buy more if the forward price is less than the expected annual price

(it won’t be)

Competing incumbents

£/MWh

MWh

Industry Demand

Small customers

Large customers

Annual wholesale price

Entrants’ sales

Competing incumbents

£/MWh

MWh

Industry Demand

Small customers

Large customers

Annual wholesale price

Entrants’ sales

Profits

Retailprice

Competing incumbents

£/MWh

MWh

Industry Demand

Small customers

Large customers

Annual wholesale price

Entrants’ sales

Profits

Retailprice

Competing incumbents

Profits

Annualprice

Forwardprice

No cover

Competing incumbents

Profits

Annualprice

Forwardprice

No cover

Forward cover

The competing firm

• Will only buy contracts if their price is less than the expected annual price

• Buys fewer contracts than the regulated firm

• Faces a higher annual price

• Might face a lower forward price

- if risk aversion is great enough

Calibrating the model

• Use values reflecting early-90s England

• Marginal Cost £20/MWh

• Equilibrium (no contracts) £30/MWh

• Equilibrium (no risk-aversion) £26/MWh

• Variance of the annual price 5.76(annual average Pool price, 90-

01)

The impact of risk and competition

25.5

26

26.5

27

27.5

28

0 0.1 0.2 0.3

Avg Price, £/MWh

2.6 4.7 8.3 11.4

Regulation

Competition

(% change in profits needed to offset 10% point rise in c.v.)

Conclusions

• Firms are buying & selling in annual markets

• Retail competition does reduce long-term contracting

• Risk aversion probably not great enough for this to have a very large impact

• Results may be sensitive to model design

• Impact of contracts on entry not studied