Contracts and risk on

electricity markets

Context

Power markets are rapidly evolving due to liberalization.

Incumbent monopolies are declining as we can see with the state of EDF.

Competition in power market is slowly but surely growing.

An example : The antitrust case of EDF by the European Commission.

Objective of this essay

Understanding the fundamentals behind transactions on the power market.

What are the fundamentals behind a system where multiple means of

transactions coexists?

Analyzing risk and its management for agents.

How agents are apprehending this specific rational on power market?

Reviewing implications of electricity transactions for electro-intensive

industry.

An economic and financial approach of the subject.

Power markets and multiprice system

The French power market

• A wholesale market with

• Spot transactions

• Intraday; day-ahead; week-end

• Futures

• Monthly; quarterly; (weekly?)

• Standardized long term contracts

• Yearly

• An over-the-counter market

• With mostly long term contracts

• Observations:

• A hierarchy

• An evolution

Two cases study: California’s crisis

and the NETA

California: An example of a failed restructuring program and of a spot based

market.

Illustrate the need of a second bilateral market and hedging tool for consumers.

The reference: Joskow in California's electricity crisis (2001)

The NETA: A program with an aim to replace a spot market by a market

“based on bilateral trading between generators, suppliers, traders and

customers” (National Audit Office, 2003)

The new market still have short term tools but they are either agreements or

transactions used for balancing the system

First step: Risk allocation – Polinsky’s

Model

• Many questions:

• How those different type of transaction affect it?

• Will the spot market will increase the risk of suppliers or of buyers?

• Do the characteristics of the buyers have a significant impact?

• An answer from theory decision: the best mean is the one that minimizes the risk.

• In this case, mean of transaction are seen as insurance tool.

• Polinsky. (1986). Fixed Price versus Spot Price Contracts: A Study in Risk Allocation.

Second step: equilibrium in a multiprice

system - Hubbard and Weiner’s Model

• Need for a deeper analysis of the market with an optimal price and quantity

for contract and spot transactions.

• This analysis will allow us to find the optimal situation for agents where two

means of exchange exists: one with a fixed price and one with a flexible price.

• Hubbard, & Weiner. (1992). Long-Term Contracting and Multiple-Price

Systems.

Other rationales

Wolak. (1996). Why Do Firms Simultaneously Purchase in Spot and Contract Markets? Evidence from the United States Steam Coal Market.

Quantity risk

More an agent avoids quantity shortage more the demand for contracts will be high.

Market structure

An increasing number of sellers will lower transaction costs and lead to an higher demand for spot transactions.

Williamson. (1979). Transaction-Cost Economics: The Governance of Contractual Relations

Contractual relations

Based on game theory, spot transactions can be regarded as a reward or an incitation to not breach a contract.

Teece. (1976). The multinational corporation and the resource cost of international technology transfer

To sum up: what theory and reality

show?

Actual markets highlights the complexity of the existence of multiple means

of transaction.

Such systems exist due to the specific nature of electricity.

The evolution of a multiprice system depends on many factors, the main one

is risk, but also on:

The origin of uncertainty, supply and demand characteristics, risk aversion …

Arbitrages between spot transactions and long term agreements can be seen

as a way of reducing this risk.

Risk management on power marketsFutures as arbitrators tools.

The demand for futures

Firm 2

𝑛𝑜𝑡 𝑒𝑛𝑡𝑒𝑟𝑖𝑛𝑔 𝑒𝑛𝑡𝑒𝑟𝑖𝑛𝑔

Firm 1

𝑛𝑜𝑡 𝑒𝑛𝑡𝑒𝑟𝑖𝑛𝑔 0.111; 0.111 {0.0625; 0.75}

𝑒𝑛𝑡𝑒𝑟𝑖𝑛𝑔 0.75; 0.0625 0.08,0.08

• A strategic tools that can appears even

without uncertainty

• A game theory approach to explain the

existence of such contracts.

• A duopoly and a prisoner dilemma

• With Cournot and Stackelberg games

• Allaz, & Vila. (1989). Cournot Competition,

Forward Markets and Efficiency.

Other implications of futures on power

markets

Futures increase liquidity by raising the demand for spot transaction.

Termini. (2007). Spot, Bilateral and Futures Trading in Electricity Markets.

Implications for Stability.

An important role on power markets where price are highly volatile.

Futures mitigate market power by reducing price to marginal cost

Termini. (2007) and Allaz, & Vila. (1989)

Also very present on power markets due to historical but also economic reasons.

Application for the electro-intensive

industry Definition and review of the Exeltium consortium

Legal definition

At the beginning:

The ratio between the electricity consumed and the added value of the firm is above 2.5 Kwh/€.

55% of the total annual consumption has to be during baseload (between 8 pm and 8 am);

A ratio between the energy consumption below a certain power threshold and the higher power or equal to 8 000 hours;

The eligibility of the CSPE;

New conditions:

A firm is electro intensive when it is in a sectors which takes part in the European exchange of C02 quotas with an intensity of at least 4%;

A site is considered electro intensive when its annual consumption is at least 5OGWh;

A site is considered hyper electro intensive when its ratio between the electricity consumed and the added value of the firm is above 6 Kwh/€ and when the firm is in a sectors which takes part in the European exchange of C02 quotas with an intensity of at least 25%;

Electro-intensive industry and electricity

Those industries are particularly vulnerable to any change in electricity price.

Electricity count for more than 6 % of their revenue.

A proof: French authorities decided to protect those industries by lowering price constraints.

Based on a study, an increase of 1% of the electricity cost leads to a decrease of 0.14% of the production in the paper industry.

Bordigoni. (2013). Détermination du rôle de l’energie dans la compétitivité de l’industrie manufacturière : Etudes économétriques et modélisation des interdépendances.

Those observations illustrate the need for a solid and significant risk management policy.