economics masters thesis - presentation
TRANSCRIPT
Long-‐term contracts and entry deterrence in the French electricity market
Author: REID, Christopher
Supervisor: SPECTOR, David
Referee: TROPEANO, Jean-‐Philippe
Motivation
• March 2010: decision by the EC in EDF long-‐term contracts case
• EDF sCll dominant on electricity market: • large market share • barriers to entry: resale, regulatory framework, informaFon on customers • size of client porIolio • verFcal integraFon (variety of means of producFon)
• Foreclosure of market through supply contracts: • volumes • duraFon • nature of contracts
• EDF commitments made legally binding by EC: • 65% of electricity supplied to large industrial consumers returns to the
market each year • Limit duraFon of contracts without free opt-‐out to 5 years • Allow compeFFon during contract period
Literature review
• In the mid 20th century there were several cases in which the U.S. judges found exclusionary contracts to be anFcompeFFve and illegal
• Chicago School response: compensaFon for lost customer surplus exceeds monopoly profits à exclusionary contracts not profitable (Director and Levi, 1956)
• Aghion and Bolton (1987): buyers sign exclusionary agreement despite jointly preferring to refuse à contracts may be used profitably • Relies on economies of scale, liquidated damages, and condiFonal offers
• Rasmussen, Ramseyer, and Wiley (1991): incumbent may exclude rivals by exploiFng buyers’ lack of coordinaFon • Does not require previous assumpFons
• Financial forward contracts: entry deterrence effect depends on mode of compeFFon • Allaz and Vila (1987): Cournot compeFFon à compeFFon is increased • Mahenc and Salanié (2003): Betrand compeFFon à compeFFon is reduced
French electricity market
• Very large share of electricity produced from nuclear power: • 75% of total producFon • 60% of installed capacity
• Compared to fossil fuels, nuclear power has: • Low operaCng costs à mostly provides base demand • High capital costs à makes entry difficult
• Our model of the French electricity market has two segments: • ConvenConal: infinite capacity, marginal cost P • Nuclear: capacity K, marginal cost c < P, investment cost b
• We focus on compeCCon in the nuclear segment • the convenFonal segment is considered perfectly compeFFve
Monopoly
• We begin by calculaFng the nuclear capacity K* such that: • Total welfare is maximised • Monopoly profit is maximised
• Total welfare = consumer welfare + total profit = indirect uClity -‐ total cost
• Prices are just a transfer between consumers and firms
• Demand is perfectly inelasCc, so maximizing total welfare is equivalent to minimizing total cost
• First, we need to determine the distribuFon of demand
Electricity demand – yearly pattern
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10
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Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Average electricity
dem
and (GW)
Date
Daily MA(7)
Electricity demand – daily pattern
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10
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Weekd
ay electric
ity dem
and (GW)
Time of day
Mean 5% 95%
Electricity demand -‐ distribution
0.000
0.005
0.010
0.015
0.020
0.025
0.030
0.035
0.040
20 30 40 50 60 70 80 90 100 110 Electricity demand (GW)
kernel uniform gamma
Electricity demand
• Electricity demand follows three paierns: • Yearly: demand is greater in winter • Weekly: demand is lower on week-‐ends • Daily: demand peaks in the evening
• For ease of calculaCon, we fit a uniform distribuCon • Parameters are chosen to match the mean and standard deviaFon of electricity demand
Name Value (GW)
Dmin 33
Dmax 78
Mean 55.5
Standard deviaFon 13
Optimal nuclear capacity – cost minimization
• The total cost of producing electricity is:
• The opFmal capacity saFsfies:
!
!
!
Optimal nuclear capacity – pro?it maximization
• The nuclear monopoly profit is given by:
!
• The profit-‐maximizing capacity is given by:
!
• This is the same expression as before!
Optimal nuclear capacity
!
• The capacity that maximizes total welfare also maximizes the profit of the nuclear monopoly. Indeed:
• R is the total payment from consumers to producers. The price of electricity is P regardless of its source, so R is a constant.
• Hence, maximizing monopoly profit is equivalent to minimizing total cost.
Model calibration • We calibrate our model so that K* = 63 GW, the total nuclear capacity currently installed in France.
• Senng b = 1 (numéraire price), we obtain P – c = 3, and Π(K*) = 96.
-‐60
-‐40
-‐20
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0 10 20 30 40 50 60 70 80 90 100
Mon
opoly profi
t
Monopoly capacity (GW)
Duopoly
• We now introduce a second firm in the nuclear market. • Firm 1, the incumbent, has capacity k1 = 63 GW • Firm 2, the entrant, has capacity k2 < k1 • Both firms have marginal cost c and investment cost b
• The firms compete via a centralized aucFon mechanism described in Fabra, von der Fehr, and Harbord (2006)
• We denote demand by D and let θ = min(D, K). • θ is allocated to the two nuclear producers • If D > K, the excess is dispatched to convenFonal producers
Auction mechanism
• Each firm submits a bid pi . We let p = (p1, p2). • Output allocated to supplier i is denoted by qi(θ, p)
!
• The lower-‐bidding firm dispatches all its capacity • If demand exceeds this capacity, then the higher-‐bidding firm serves residual demand.
• Discriminatory aucFon: an acFve supplier receives its offer price, so profits are given by:
!
Large ?irm pro?it
• Firm 1 operaFng profit is given by:
!
• With fixed k1, firm 1 profit is a decreasing funcFon of k2 that is: • QuadraFc when k2 < Dmin
• Linear when k2 ≥ Dmin
• Firm 1’s opFmal choice of capacity is:
!
Small ?irm pro?it
• Firm 2 operaFng profit is given by:
!
• With fixed k1, firm 2 profit is a conFnuous funcFon of k2 . • It is cubic when k2 < Dmin
• When k2 ≥ Dmin, the expression involves log(k2) and powers of k2
• The opFmal capacity for firm 2 is given by • When k2 < Dmin, k2* is the soluFon to a quadraFc equaFon. • When k2 ≥ Dmin, the equaFon must be solved numerically.
!
Duopoly: individual pro?its
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0 5 10 15 20 25 30 35
Profi
t (aX
er investmen
t costs)
Firm 2 capacity (GW)
Firm 1 Firm 2
• Firm 2 chooses capacity k2* = 17.5 GW and makes profit 19. • Firm 1 profit is then reduced by about 50% (from 96 to 51). • Note: any capacity below Dmin is profitable for firm 2.
Duopoly: total pro?it, cost, and revenue
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Capacity of firm 2 (GW)
total profit total cost total revenue
• Entry by firm 2 leads to excess capacity, driving up total cost • Total profit falls: firm 2 profit does not compensate profit lost by firm 1 • Net price (P – c) is proporFonal to total revenue: it falls by 10% when k2 = k2*
Introducing contracts • We introduce long-‐term contracts in the following manner:
1. Firm 1 has a monopoly and chooses a volume f of long-‐term contracts. 2. Firm 2 observes these contracts and builds capacity k2*( f ). 3. The two firms compete on the spot market.
• The contracts sFpulate that firm 1 supplies power to customers at a constant level f for price pf = P.
• The contracts are “long term” in the sense that they are sFll in effect when firm 2 enters the market.
• The size of the spot market is reduced by f: • Dmin’ = Dmin – f • Dmax’ = Dmax – f • k1’ = k1 – f
Contracts: ?irm 2 capacity
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0 5 10 15 20 25 30 35
Capa
city (G
W)
Volume of contracts held by firm 1 (GW)
k2 Dmin -‐ f
• Capacity chosen by firm 2 is strictly decreasing in f • The reducFon in k2 is approximately proporFonal to f / k1 • There is a change in slope when f > 23.7 GW: then k2*( f ) > Dmin’
Contracts: individual pro?its
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0 5 10 15 20 25 30 35
Profi
ts (a
Xer investmen
t costs)
Volume of contracts held by firm 1
Firm 1 Firm 2
• Firm 1 profit is strictly increasing in f but remains below monopoly level • Firm 2 profit is strictly decreasing in f but remains above zero à Firm 1 cannot exclude firm 2 completely unless there are large fixed costs
Contracts: total pro?it and total cost
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90
0 5 10 15 20 25 30 35 Volume of contracts held by firm 1 (GW)
Total profit Total cost
• Total profit is increasing in f but remains below monopoly level • Total cost is decreasing in f as excess capacity is reduced
Contracts: total revenue
50
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170
0 5 10 15 20 25 30 35
Total reven
ue
Volume of contracts held by firm 1 (GW)
Including contracts Excluding contracts
• Total revenue, including revenue from contracts, is increasing in f • Total revenue excluding contracts (spot market revenue) is decreasing in f as the size
of the spot market is reduced.
Contracts: spot market price • We define an index of the spot market price:
!
2.68
2.685
2.69
2.695
2.7
2.705
2.71
2.715
2.72
2.725
0 5 10 15 20 25 30 35
Spot m
arket p
rice inde
x
Volume of contracts held by firm 1 (GW)
• Pavg = spot market revenue / spot market size • Both quanFFes are decreasing with f, so the effect of long-‐term contracts on spot
market price is ambiguous • Changes in price are very small: it remains within 1% of its value with free entry
Conclusion
• In the absence of contracts, market entry leads to excess nuclear capacity. • Total cost increases • Total profit decreases • Price decreases
• Long-‐term contracts reduce entry but cannot eliminate it enFrely (unless the rival has large fixed costs). • Incumbent can increase profit but cannot recover monopoly profit
• The price of electricity on the spot market is not significantly affected by contracts • It remains at the free entry level
• Extensions: • IncenFves • RegulaFon
References Aghion, Philippe, and Patrick Bolton. "Contracts as a Barrier to Entry." American Economic Review (1987): 388-‐401. Allaz, Blaise, and Jean-‐Luc Vila. "Cournot compeFFon, forward markets and efficiency." Journal of Economic Theory 59, no. 1 (1993): 1-‐16. Bessot, Nicolas, Maciej Ciszewski, and AugusFjn Van Haasteren. "The EDF long term contracts case: addressing foreclosure for the long term benefit of industrial customers." CompeEEon Policy NewsleGer 2 (2010): 10-‐13. Director, Aaron, and Edward H. Levi. "Law and the future: Trade regulaFon." Northwestern University Law Review 51 (1956): 281. Lien, J. “Forward Contracts and the Curse of Market Power”, University of Maryland Working Paper (2000) Mahenc, Philippe, and François Salanié. "So{ening compeFFon through forward trading." Journal of Economic Theory 116, no. 2 (2004): 282-‐293. Fabra, Natalia, Nils-‐Henrik von der Fehr, and David Harbord. "Designing electricity aucFons." RAND Journal of Economics 37, no. 1 (2006): 23-‐46. Fabra, Natalia, Nils-‐Henrik von der Fehr, and María-‐Ángeles de Frutos. "Market Design and Investment IncenFves." Economic Journal 121, no. 557 (2011): 1340-‐1360. Rasmusen, Eric B., J. Mark Ramseyer, and John S. Wiley Jr. "Naked Exclusion." American Economic Review (1991): 1137-‐1145. Segal, Ilya R., and Michael D. Whinston. "Naked Exclusion: Comment." American Economic Review (2000): 296-‐309.