Bert Willems

Cournot Competition, Financial Option Markets and Efficiency

Bert Willems

Long Term Contracts?

Historically: Regulators opposed long term contracts Entry might be slowed down Decrease liquidity and transparency of the spot market

Currently: Regulators more in favor of long run contracts Reduce market power (Bushnell et al.) Allow Hedging (Bankruptcy California) Security of supply issues / New Entry

Policy Question: Regulation of amount of contracts signed? Type of contracts?

Options – Futures // Financial – Physical contracts? Virtual power plants / Capacity payments

Bert Willems

This paper

Strategic effect of financial call optionsGenerators freely decide about number of option

contracts they sell1 Option with 1 strike price (endogenous in model)

NOT Hedging issues Entry decisions Security of supply issues Regulation = obligation to buy/sell contracts

Bert Willems

Paper = Extension of A&V

Allaz and Villa (1993) Strategic reasons to sell Futures contract

= commitment to produce more in spot market Prisoners dilemma: markets become more efficient

My paper Replace Futures with Call Option

Results of A&V – my paper rely on Cournot competition (Mahenc and Salanie, 2004) Observability of the futures position (Hughes and Kao) Perfect inter-temporal arbitrage

Bert Willems

Why Options?

Why look at options? Hedge quantity risks Retailers can counter market power of generators in

peak period Incomplete markets solved by options

Two types Physical options

a plant is assigned to the option contractproduction decision is delegated to market

Financial optionmonetary transferproduction decision stays with firm

Bert Willems

Comparison with C&W (2004)

CHAO & WILSONOblige generators to sell

physical call options

Perfect regulation of options sold

Entry in the contracting stage

Bundle of options one option of each strike price

Linear supply functions Physical options

Allowing for entry and imposing optimal regulation voids any comparison of contract types

Non-standard assumptions on

option types type of competition

DISCLAIMER: My interpretation of earlier work !

Bert Willems

Solution

CHAO & WILSONOblige generators to sell

physical call options

Perfect regulation of options sold

Entry in the contracting stage

Bundle of options one option of each strike price

Linear supply functions Physical options

THIS PAPER

Quantity is endogenous

Number of generators is fixed

One optionone pre-specified strike price

Cournot competition Financial options

comparison with A&V

Bert Willems

Two Stage Game

ContractingStage

ProductionStage

Generators sell ki

LT-contract at a price F

1 21.5

Generators learn each other’s contracting position

Generators sell qi

electricity on spot marketGenerators payout insurance

TIME

Pay Off

with ( ) ( ( ) )i i i iP q C q k V P F× - - -

1 2( )P pq q= +

Perfect arbitrage( )V P F=

Financial call option

= Insurance contract for prices above strike price S

Payment ( ) max{ ,0}V P P S= -

Futures contract

= Mutual Insurance against deviations of the futures price F

Payment ( )V P P=

( )ikV P

Reduced Pay Off

with

1 2( )P pq q= +2

1 2( , )ndStage

i iq q k k=

( )i i iP q C q× -

Bert Willems

Second Stage

Effect of ownership of futures More aggressive behavior of generator Own reaction functions shifts out

P > S: option in the money same reaction function as with Futures

P< S: option is out the money same reaction function as standard

Cournot P=S: Several Equilibria in 2nd stage if a

lot of options are sold

0 0.2 0.4 0.6 0.8 10

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

q1

q 2

Forward - Equilibrium

( )i i iP q C q× -

Futures Contracts for Firm 1

0 0.2 0.4 0.6 0.8 10

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

q1

q 2

Forward - Equilibrium

( )i i iP q C q× -

Option Contracts for Firm 1

1 2( )pq q S+ =

Bert Willems

First Stage

Futures increases number of futures

Market share increases Spot price goes down

Prisoner’s Dilemma: sell forwardsOptions Multiple Nash equilibria in second stage

No obvious focal point Punishment equilibria possible

Assumption: generators co-ordinate on equilibrium highest priceLow price: generators sell a lot of options in the first stage

Risky, assumes perfect co-ordination in the N.E. High price: Lower profit in general with higher prices

Bert Willems

Conclusions

Financial Call options increase market efficiency Comparison with futures contracts

Depends on strike price High Strike price (A)

Futures are better

Low Strike price (B) Futures = Option

Intermediate prices (C) Futures are better

Equilibrium Selection is important

,C eqP

S

AVP

P

45o

,C eqP

AVP

A

C

B

Bert Willems

Extensions

Physical options vs. Financial options Two different types of property rights Prisoner’s dilemma with Physical options is not there See Working Paper

Other types of Financial insurance contracts Insurance contracts which pay relatively more when

prices are high: more competitive market Work in progress

Bert Willems

Future Work: Investments + Entry

LT-contracts + Entry Lower risk (risk aversion) Retailer and entrant (partially) internalize reduction of

market power

Role of options? Better hedging of quantity risks

NEEDED: Extend model with uncertainty – risk aversion

Bert Willems

Future Work: Regulation Under-contracting by retailers

W.r.t. market power mitigation and reliability Reason: missing markets Contracting is public good

Regulation of long term contracts? Should retailers / producers be obliged to buy/sell?

Role of options Options might be cheaper regulatory instruments Only put constraints on markets when there is a problem Market conform

NEEDED Model for market imperfection

missing markets (Explaining under-contracting by private players) market power

Model for regulation costs Asymmetric information? Incomplete contracting?

Regulatory efficiency Improved Market EfficiencyRegulation Cost