withholding investments in energy only markets
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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
Models used in the research
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
Models used in the research
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
Theoretical model 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 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
Theoretical model 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 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
No impact of contracts when the pattern of
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.
No impact of contracts when the pattern of
binding capacity is unchanged
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.
No impact of contracts when the pattern of
binding capacity is unchanged
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
No impact of contracts when the pattern of
binding capacity is unchanged
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.
Impact of contracts when the pattern of
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.
Impact of contracts when the pattern of
binding capacity is changed
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.
Impact of contracts when the pattern of
binding capacity is changed
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.
Impact of contracts when the pattern of
binding capacity is changed
Finding an equilibrium in the capacity game
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.
Finding an equilibrium in the capacity game
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
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