Contracts and Electricity Pool Prices

by

JOSHUA S. GANS, DANNY PRICE and KIM WOODS*

First Draft: 29 May, 1997

This Version: 24 February, 1998

This paper examines the interaction between forward contracts for

electricity and electricity spot markets. Using a Cournot model of electricity
pools it is demonstrated that generators have a purely strategic incentive to
sign forward contracts so as to raise their market share, by lowering price over
the elastic portion of their individual demand curves. This, in turn, implies
that the existence of the contract market lowers prices in pool markets and
hence, over the industry. By mutually committing not to sign contracts,
generator profits would be higher. However, the existence of the contract
market precludes such pre-commitment. We demonstrate that when there are
asymmetries between generators, contracting also allows efficient plants to
operate relatively more, lowering the cost structure of the industry. Finally,
we consider the effect of contracts on entry and find that it is possible that the
existence of a contract market could deter otherwise efficient entry. Journal
of Economic Literature Classification Numbers: L13, L94.

Keywords: electricity pools, contracts, strategic effects, entry deterrance.

*
University of Melbourne, London Economics and London Economics, respectively. Financial assistance
from London Economics is gratefully acknowledged. In addition, we thank Frank Wolak for helpful
discussions and participants at the 1997 Industry Economics Conference and two anonymous referees for
comments. All views expressed in this papers are those of the authors and do not reflect the views of
London Economics. Please address correspondence to Joshua Gans, Melbourne Business School, 200
Leicester Street, Carlton, Victoria, 3053; Fax: (03) 9349 8133; E-mail: J.Gans@mbs.unimelb.edu.au. The
latest version of this paper will be available at: http://www.mbs.unimelb.edu.au/home/jgans.
 2

I. Introduction

In recent years, the electricity sector has been transformed from a vertically

integrated monopoly to a disintegrated one that is capable of generating competition in both

generation and retailing. This change has been well established in England and Wales and

now in Victoria and New South Wales. South Australia and Queensland face similar

reforms with an eventual formation of the National Electricity Market.

The change in the structure of electricity production has come about because of the

establishment of a spot or pool market for electricity generation. This pool is characterised

by generators making half-hourly bids of generation and a price schedule and a pool

operator using these bids as the basis for a dispatch schedule. Generators then receive the

system marginal price (SMP) on all units dispatched. The SMP is the highest price paid for

any unit dispatched. Economists have begun to model this pool market behaviour as either

an equilibrium in supply functions (Green and Newbery, 1992) or, alternatively, as a

multi-unit simultaneous auction (von der Fehr and Harbord, 1993). These analyses have

shown that pool markets may not produce competitive outcomes if there are a small number

of dominant generators. Hence, pool prices may be substantially above marginal cost.

Side by side with pool markets are both long and short-term contract markets for

electricity. By writing contracts, generators and retailers can share risks associated with a

fluctuating pool price. But concern has been raised that the imperfect competition of pool

markets will simply translate into market power being exercised in contract markets.

Therefore, the existence of a contract market may allow generators further leverage over

retailers.

The purpose of this paper is to explore the linkages between pool and contract

market power. In many respects it is a simple exposition and unified consideration of

issues explored by previous researchers. Von der Fehr and Harbord (1992) model the pool

as a multi-unit auction and demonstrate that contracts give generators a strategic advantage

in the pool market by allowing them to commit to supply greater quantities during peak
 3

demand periods. However, their model suffers from the disadvantage that the contract

prices are held fixed when in reality they will adjust over time depending on potential pool

market behaviour. Powell (1993) considers the interaction between contract and spot

markets and draws on some of the competitive conclusions below. His model views

contract deals and spot market bidding as simultaneously determined. Our model below

considers the role of pre-emptive contracting before spot market trading occurs. Finally,

Green (1996) appropriately looks at the endogenous formation of both pool and contract

prices in a supply function model. His analysis in many ways mirrors some of the

conclusions below. However, his reliance on the complex, albeit descriptively accurate,

supply function model makes it difficult to analyse how alterations in the cost structure of

generation influence the exercise of market power.

In this paper we use a Cournot model of pool market behaviour that lies at one

extreme of the supply function models -- where the ability of generators to influence market

power by making quantity commitments is greatest.1 In addition, we model both

generators and retailers as risk neutral and hence, there are no risk sharing benefits in

signing long-term contracts. Nonetheless, we are able to show that contracts are signed

and, in contrast to the concerns of some, make electricity markets more, not less,

competitive. The existence of contracts in some instances improves efficiency directly by

affording more efficient generators a greater market share. We then turn to consider the

effect of the contract market on entry decisions. A final section concludes with remarks

about the role of contracts in investment.

1
Grant and Quiggin (1996) demonstrate that Cournot outcomes naturally result in supply function models
when capital pre-commitments are relatively inflexible, as in electricity generation investment. This is a
commonly used specification to model electricity pools. See also Powell (1993) and Borenstein, Bushnell
and Stoft (1997). In addition, Wolak and Patrick (1997) provide empirical evidence supporting competition
in quantities.
 4

II. An Overview of Electricity Contracts

While the analysis to follow will eliminate risk sharing aspects of contracting, these

are the concerns that provide a rationale for the existence of contract markets. Therefore, it

is worth reflecting, initially, on the role of long-term contracts in this regard.2

To generators and retailers the greatest risk posed by electricity pools is the financial

consequences of fluctuating pool prices. Pool prices will vary each half hour and will be

determined by the balance of supply and demand. Whilst the level of demand can be

estimated, the availability of generation capacity in the market is less predictable.

Generators themselves will choose how much electricity they will offer to produce. The

power station with the highest marginal bid that is operating at any point in time (and the

price they require to operate) determines the pool price.

In addition, availability is also affected by forced/partial outages which are not

anticipated. These uncertainties about availability consequently affect the stability of pool

prices in the short, medium and long term. Therefore, generators and retailers may wish to

cover themselves for this pool price risk by taking out an option contract (which are known

in the UK as Contracts for Differences or CfDs).

These contracts are purely financial transactions. When these option contracts are

set alongside physical sales or purchases from the pool provide insurance against excessive

fluctuations in the pool price. These contracts are used in the UK, Victoria, NSW and a

similar contract market will operate in the NEM. For example, vesting contracts are simply

a financial hedge with a range of cross-subsidies added into the contract price. The nature

of these contracts is described below.

2
A short-term day ahead contract market is also proposed for the NEM. This market is not the focus of
this paper.
 5

Contract components

All contracts types have two common elements; a strike price and a quantity.

However, many are more complex, with multiple strike prices for different times of the day

or periods of the year and contract quantities which may be ‘sculpted’ over the course of

the year. Further, some contracts can only be ‘called’ during certain periods, such as peak

times.

The key components of a contract are listed and briefly described below:

• one-way/two way options; the contract may be called by the holder (retailer) or seller
(generator) of the option, depending upon how the option is defined;
• firm/non-firm capacity; the contract may be firm or related to the availability of
particular generating sets;
• strike price; this will set the price level at which the contract can be called. It can be
varied by time or day. It can also be escalated from year to year;
• maximum capacity; the amount of capacity for which the contract can be called can be
‘sculpted’ by time of day or year to match a purchaser’s load shape;
• maximum and minimum takes; safeguards can be set against the contract being called
too much or too little by constraining the number of takes;
• option constraint; the hours in which the option can be called, whether or not the strike
price is below pool price, can be limited; and
• length of contract; this determines the overall commitment to the contract terms.

Basic contract types

There are essentially two forms of these contracts: one-way and two-way. One-

way contracts establish a ceiling pool price (the strike price), as illustrated in Figure 1. If

the price is below the ceiling price retailers pay the pool price, if it is above the ceiling price

retailers still pay the pool price but are compensated by the generator for the difference

between the ceiling and pool price.

Generators sell the contracts to distributors for a fixed option fee. If both

contracting parties are risk neutral, the value of the option fee would be equal to the net

present value of the difference between expected pool purchase costs and purchase costs
 6

under the contract (net of the option fee). That is, the net present value of the expected pool

price and the contract price is the same. Since the expected pool price is used to determine

the amount that a buyer would pay for the option fee, it is important to predict the future

pool price path as accurately as possible to minimise contract trading costs.

 7

Figure 1 One-way contracts

Pool price

Generator pays retailer

Strike price

Time

Two-way contracts work in a similar way to one-way contracts. The difference is

that a two-way contract establishes a firm price for both generator and retailer (see Figure

2). Two-way contracts for differences are like forward contracts - retailers and generators

essentially have agreed to buy/sell electricity for a fixed price over a fixed period in the

future. Therefore, two-way contracts are not normally associated with option fees. Under

a two-way contract, if the pool price rises above the strike price, generators compensate

retailers for the difference. But if pool price falls below the strike price, then retailers

compensate generators for the difference. The net present value of the strike price should

approximate the net present value of the pool price.

Generally, one-way contracts are the preferred form of cover against infrequent

events, such as pool prices moving above $300/MWh. Thus, the generator bears the risk if

the pool price falls below the strike price; they will not be compensated for downward

shocks.
 8

Figure 2 Two-way contracts

Pool price

Generator pays retailer

Strike price

Retailer pays Retailer pays

generator generator

Time

Two-way contracts are preferred when broader coverage is required. In these

events the main advantage of the two-way contract is that it reduces generator exposure to

revenue risk when pool prices fall below contract strike price. Under a one-way contract

generators are exposed to this risk. To the extent that generators will be risk adverse they

will prefer two-way to one-way contracts. This has happened in Victoria. Two-way

contracts are generally used to cover base load demand and part of their intermediate

demand. One-way contracts are used for intermediate and peak demand.

While the role of one-way contracts is to hedge against the pool price risk borne by

retailers, two-way contracts involve both retailers and generators sharing risk and, as will

be demonstrated below, an additional strategic advantage to generators. As such, this

paper will focus exclusively on two-way contracts for differences.

 9

III. The Strategic Effects of Contracts

We begin by considering a simple model of Cournot duopoly competition. As

mentioned earlier, our decision to focus on the Cournot case is to demonstrate most clearly

the existence of strategic effects to contracting. This allows us to use a simple framework

to explore the comparative statics associated with such contracting (cf: Green, 1996). The

restrictive assumptions we employ are for ease of exposition and can be generalised quite

easily.

There are two generators in the industry each subscripted by i = 1, 2. Inverse

industry demand for electricity is a linear function p = A − b(q1 + q2 ) . This is simply the

inverse load duration curve for a particular time period. It represents the choices of retailers

and customers which are unmodelled in this paper. While industry demand is stochastic in

practice, here we will ignore this possibility -- this is a reasonable restriction given our

assumption the generators and retailers are risk neutral. Generator production costs are

linear with Ci (qi ) = ci qi , where we assume initially that c1 = c2 = c . There are potentially

capacity restrictions on generators. Consideration of these will be left to a later section.

Finally, we assume that A > ci for all i so that each firm’s output is positive in equilibrium.

It is worth remarking upon our demand specification. In most electricity pools,

demand is perfectly inelastic in any given time period (Patrick and Wolak, 1997).

However, contracts are signed over a longer time horizon. Over those time periods,

demand is more elastic. As this paper considers stable equilibria in both the contract and

spot markets, it is this latter specification that is more appropriate.3 As retailers will come

to expect future spot prices, this will be built into their daily demand for electricity. As

such, quantity demanded will respond to price.

The game between generators proceeds in two stages. In the first stage, generators

can pre-emptively contract with retailers. That is, they each choose, x i, their contracted

3
This has been the approach followed by others (see Green and Newbery, 1992; Powell, 1993).
 10

quantity, with the strike price, z, a function of their competition in contracting. In the

second, spot market competition in the pool occurs. As will be shown, what occurs in the

latter stage is influenced by the first. This is because both generators and retailers have

rational expectations regarding what price will result in the pool in stage two. Indeed,

given the assumption of risk neutrality, no retailer will sign a contract with a strike price

less than the expected spot price and generators will, in equilibrium, not find it

advantageous to offer lower contract prices than expected spot prices. Therefore, agents

will expect that z = p.

We will analyse the model by working backwards considering stage two pool

market behaviour contingent on any feasible contract set signed and then looking at contract

market behaviour in which all parties expected the predicted stage two behaviour.

Stage Two: The Spot Market

Suppose that both generators have signed contracts for amounts ( x1 , x2 ) in stage

one. A generator’s profits in stage two will then be:

π i = p(qi − xi ) + zxi − cqi .

Given our Cournot assumption, each generator chooses qi to maximise this function,

holding the quantities of all other generators as given. While marginal cost is always c,

marginal revenue is − b(qi − xi ) + p ; that is, it is linear and intersects the demand curve at at

qi = xi. Contracts alter the intercept of the marginal revenue curve. In particular, when qi <

xi, marginal revenue lies above average revenue because the generator will effectively be a

net buyer into the pool, giving it an incentive to push prices down. Nonetheless, the key

point here is that while marginal incentives are dependent on the quantity of contract cover,

they are independent of its strike price.

We can solve for the reaction function for an individual generator, i:

 11

A − bq j + bxi − c
qi = .
2b
The key feature to note about this function is that it is increasing in own level of contract

cover and only depends on the level of contract cover of the other generator through that

generator’s quantity. The intuition for this relationship can be best demonstrated

graphically. Figure 3 depicts the inverse demand curve facing generator 1 for a given q 2 .

It also depicts the marginal revenue curve facing that firm when it has no contract cover.

Note that the marginal revenue curve when it has contract cover of, say, x1units of contract

cover, is higher than the marginal revenue curve without contract cover. For a constant

marginal cost, the quantity at which marginal revenue equals marginal cost is greater when

the generator has signed a forward contract for some quantity. This occurs regardless of

the quantity chosen by the other generator, hence, pushing the reaction curve upwards.

It should be noted that when a generator contracts some output, regardless of the

strike price on that contract, it should bid that contracted amount into the pool at marginal

cost. This ensures that when the pool price is above marginal cost, the generators

contracted amount is dispatched. If it were not dispatched it would be effectively forced to

act financially as if it had bought the unproduced portion of the contract at pool prices.

Thus, if individual demand facing a generator were relatively low, it may find itself not

producing its full contracted amount. While this is optimal if the pool price is below

marginal (or avoidable) cost, the generator is strictly better producing this quantity if the

pool price is above marginal cost. Note that a firm whose output is entirely contracted,

i.e., with xi = qi , ends up with price equal to marginal cost. This mirrors a result

demonstrated by Green (1996) for restricted supply function equilibria.

 12

Figure 3: Effect of Contracts on Pool Quantities

p
MR (No Contract)

MR (Contract)

MC
c

x1 q1

q2

1’s Reaction
(No Contract)

1’s Reaction
(Contract)

2’s Reaction

q1

Solving out for the unique equilibrium in the stage two subgame, we have:

qi = 1
3 ( 1
b )
( A − c) + 2 xi − x j for all i and p = 1
3 ( A − b( x1 + x2 ) + 2c).
Observe that price is lower when the sum of contract cover is greater. Moreover, whenever

one generator increases its contract cover relative to the other, its quantity sold is greater

while the quantity sold by its rival is lower. As depicted in Figure 3, the assumption of
 13

Cournot competition means that each generator’s quantity choice is decreasing in those of

its rivals (i.e., they are strategic substitutes). Greater individual contract cover raises the

returns to having higher quantities in the pool. As such, it raises a given generator’s output

but also results in reduced output by other generators and a lower pool price overall.

Therefore, by encouraging generators to bid a greater quantity into the pool at any

given time, contracts have a strategic effect on the equilibrium in stage two. Note that in

Bertrand competition the pool price equals marginal cost always so that the amount of

contract cover does not have this strategic effect. It is only when generators can make

quantity commitments (even partly), that the strategic implications of contracting are

realised.

Stage One Contract Market

Each generator and retailer realises that contracts have effects on pool prices. For

each generator, greater contract cover raises their incentives to bid larger quantities in the

pool and forces others to reduce their quantities, all other things being equal. The lower

pool prices will mean that retailers will demand a lower strike price for any contract signed,

however. The question is, what will happen when each generator competes for these

contracts?

As noted earlier, in equilibrium z = p, i.e., z = 1

3 ( A − b( x1 + x2 ) + 2c) . Each

generator, therefore, anticipates the following profit in stage two:

π i = ( p − c)qi = 1
9b ( A − b( x + x ) − c)( A + b(2 x − x ) − c) .
i j i j

Once again, using this payoff, generators choose their level of contract cover, holding the

contract choices (but not the ultimate spot market choices) of the other generator as given.

In general terms, the marginal return to contracting is:

 14

∂π i dqi
= dx i ( p − b(qi − xi ) − c) − dx ij bqi .
dq

∂xi 1 4 4 4 2 4 4 4 3 12 3
=0 Strategic
Effect

The first term is zero by the envelope theorem. Under risk neutrality, there is no direct cost

or demand advantage from contracting. Therefore, the effect is purely a strategic one (a

“top dog” strategy in Fudenberg and Tirole’s (1984) terminology). This is positive for, as

noted earlier, increased contracting raises own output in the spot market reducing the

quantity bid by the rival generator.

Considering our specific model, the first order condition for the profit maximising

choice of contract level is:

∂π i
∂xi
( ( ) ) ( (
= − 19 A + b 2 xi − x j − c + 29 A − b xi + x j − c = 0 ) )
which, in the unique symmetric subgame perfect equilibrium, yields:

A−c A + 4c
x1 = x2 = and z = .
5b 5
Observe that the resulting level of output (both contracted and spot) for a generator is:

2( A − c )
q1 = q2 = ,
5b
twice the contracted level. So in this specific example, generators contract half of their

output in equilibrium.

What is the impact of contracting upon price? To conduct this experiment,

observed that if no contracts were allowed, then:

A−c A + 2c
q1 = q2 = and p = .
3b 3
Therefore, it is easy to see that by allowing for contracting, price is lower and output is

greater. So while each generator has a strategic benefit from pre-emptive contracting, in

equilibrium this possibility harms their profits. Each would prefer to commit not to

contract, but in a similar vein to the Prisoner’s Dilemma, each chooses to contract a positive
 15

amount imposing a negative effect on the other’s profits (see Allaz and Villa, 1993; for

extensions of this idea).

I V . Asymmetries Between Generators

The previous analysis considered the role of contracts in a symmetric environment.

While the strategic role of contracts and its competitive benefits continue to hold with non-

linear demands and costs, one cannot analyse whether more efficient generators use

contracts relatively more or less than less efficient ones in a symmetric environment.

Therefore, in this section, we extend our basic model to consider heterogeneous cost

structures among generators.

Consider first a situation in which generators differ in their marginal costs, i.e.,

c1 > c2 . In this case, the equilibrium is no longer symmetric. It is still unique, however,

and has the solution:

A − 3c1 + 2c2 A − 3c2 + 2c1

x1 = and x2 =
5b 5b
2( A + 2c2 − 3c1 ) 2( A + 2c1 − 3c2 )
q1 = and q2 =
5b 5b
A + 2(c1 + c2 )
z= p=
5
Note that even though q1 > q2 , each generator continues to contract half of its output.

Without contracting, we would have:

A + c1 + c2 A + c2 − 2c1 A + c1 − 2c2
p= , q1 = and q2 =
3 3b 3b
Once again, the output of both generators is higher and price lower when contracting is

possible. One can also compare the market shares of generators when contracting is and is

not allowed. Interestingly, with contracting, the market share of the more efficient plant is

higher than the case where contracting is not possible.

 16

These conclusions are not robust to alternative cost specifications. Suppose that

Ci (qi ) = ci 12 qi2 . It is cumbersome but not difficult to show that while the results of Section

III continue to hold for this cost function, generators contract a third of their output in

equilibrium but the market shares in the contracting as compared with the no contracting

case are exactly the same. Nonetheless, as one increases the marginal costs of one

generator, its output falls, the output of its rival rises, total industry output falls, contract

levels fall and each firm continues to contract one third of its output.

This example of increasing marginal costs captures part of the technology of

electricity generation. In reality, however, the capacity constraints on a generator are such

that marginal cost is relatively flat for most output below a certain level at which it becomes

very step (i.e., the marginal cost curve is an inverted L-shape). Capacity constraints of this

form are difficult to analyse. If both generators are expected to be constrained in a given

period (i.e., in periods of high demand), then neither one gains a strategic advantage from

pre-emptive contracting as this does not reduce the quantity the other bids into the pool. On

the other hand, in periods of low demand, both have strategic incentives similar to those

analysed in this paper. Thus, one would expect the degree of contract cover to vary with

the intensity of demand.

One can also ask whether large versus small generators have a greater incentive to

contract, all other things equal. Assuming equal marginal costs, small generators are likely

to be constrained more often. In a duopoly, this means that a large generator will have a

reduced strategic incentive to contract as they cannot influence the quantity the small

generator bids into the pool. In reality, when there is no duopoly, however, it is difficult to

say whether large or small generators will have a greater incentive to pre-emptively

contract.
 17

V. Contracts and Entry

The previous sections demonstrated that contracts have the effect of diminishing the

overall price for electricity and, hence, the profits of individual generators. In a static

setting, where there is no possibility of entry, this represents a welfare improvement

through greater allocative efficiency in electricity. However, lower prices and industry

profits make entry unattractive. While this would not be a concern in industries where

entry can be smooth and entrants have considerable flexibility over the scale of production,

in electricity, this is not a reasonable assumption. Entry will give rise to discrete changes

and potential entrants will have to take account of larger changes in prices received.

Once again, we ask the question: what does the existence of a contract market have

on pool prices? Newbery (1997) has analysed the interaction between contracts and entry

deterrence in electricity markets. In a model in which only incumbent generators were able

to sign contracts, he demonstrated that such contracts facilitated entry deterrence by

committing generators to lower pool prices -- below the level that would allow for entry.

In contrast, we allow a potential entrant as well as incumbents to compete for pre-emptive

contracts for differences. This seems reasonable as it will, potentially, be in retailers’

interests to encourage entry.

We analyse this case as follows. Suppose that there are two incumbent generators,

1 and 2, as in Section III who have symmetric marginal costs, c. In addition, suppose

there are no capacity constraints. There is a potential entrant, 3, who has marginal cost of c

≤ c, but must incur a sunk entry cost of F > 0. It will, therefore, enter if its expected post-

entry profits π3 ≥ F.

It is quite easy to demonstrate that entry profits are lower when there is a contract

market compared with a situation in which such a market does not exist. Therefore, there

exists a range of sunk costs, F, such that the entrant would choose to enter if there was no

contract market but would not enter otherwise. If this is the case, then the price that
 18

prevails when there is no contract market is 1

4 ( A + 2c + c) , as entry has occured.

However, when there is a contract market, entry does not occur so the price remains at its

duopoly level, 15 ( A + 4c) . In this case, a contract market serves to lower electricity prices

if and only if A − c ≥ 5(c − c), i.e., if the cost differential is small. For a large entrant cost

advantage, if F is such that entry might be deterred by having a contract market, then the

existence of contracts is potentially anticompetitive.4

In addition, it can shown quite easily that there exist parameter values under which

efficient entry is deterred by a contract market. That is, taking into account the sunk costs,

it can be shown that a potential entrant will find entry unprofitable, yet such entry would

have reduced industry-wide average costs.5 The possibility that efficient entry is deterred

becomes more likely at intermediate ranges of sunk entry costs. In reality, when entry can

occur on many different scales, the possibility that the contract market has a negative

dynamic impact on economic efficiency is reduced.

V I . Conclusions

This paper has demonstrated that contract markets can serve to make oligopolistic

spot markets more competitive. Generators have a purely strategic incentive to sign

forward contracts so as to raise their share of the overall electricity market. However, this

option has a negative effect on the profits of other generators. Each is caught in the

equivalent of a Prisoner’s Dilemma motivating them to sign contracts when it is in their

mutual interest to refrain from so doing. The result is an electricity market with prices

closer to marginal costs.

Our conclusion, however, was qualified by the possibility that the contract market

might deter entry that might otherwise occur and hence, could lead to higher electricity

4
Of course, as the cost advantage grows large the range of sunk costs that might deter otherwise possible
entry grows smaller.
 19

prices in the long-run. This analysis of the possible dynamic consequences of contracts is

only a beginning. In particular, signing a contract can make current generators less flexible

to informational changes. A fruitful direction for future research, therefore, is to consider

the interaction between pool and contract markets in a dynamic setting where each sends

signals and provides incentives for entry and investment (as in Aghion and Bolton, 1987;

Innes and Sexton, 1994; and Gans and King, 1998).

5
For instance, this occurs when A = 10, b = 1, c = 6, c = 0 and F = 38. In this case, post entry profits are
36 while the average cost reduction in entry occurred would be 1.
 20

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