Cournot Competition, Financial Option Markets and Efficiency

1
Cournot Competition, Financial Option Markets and
Efficiency
2
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

3
This paper

• Strategic effect of financial call options
• Generators freely decide about number of option
  contracts they sell
• 1 Option with 1 strike price (endogenous in
  model)
• NOT
• Hedging issues
• Entry decisions
• Security of supply issues
• Regulation obligation to buy/sell contracts

4
Paper Extension of AV

• 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 AV my paper rely on
• Cournot competition (Mahenc and Salanie, 2004)
• Observability of the futures position (Hughes and
  Kao)
• Perfect inter-temporal arbitrage

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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 contract
• production decision is delegated to market
• Financial option
• monetary transfer
• production decision stays with firm

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Comparison with CW (2004)

• CHAO WILSON
• Oblige 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 !
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Solution

• CHAO WILSON
• Oblige 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 AV
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Two Stage Game
Contracting Stage
Production Stage
TIME
1.5
1
2
Generators sell ki LT-contract at a price F
Generators learn each others contracting position
Generators sell qi electricity on spot
market Generators payout insurance
Pay Off with
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Second Stage

• P gt S option in the money
• same reaction function as with Futures
• Plt S option is out the money
• same reaction function as standard Cournot
• PS Several Equilibria in 2nd stage if a lot of
  options are sold

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

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First Stage

• Futures
• increases number of futures
• Market share increases
• Spot price goes down
• Prisoners Dilemma sell forwards
• Options
• Multiple Nash equilibria in second stage
• No obvious focal point
• Punishment equilibria possible
• Assumption generators co-ordinate on equilibrium
  highest price
• Low 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

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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

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Extensions

• Physical options vs. Financial options
• Two different types of property rights
• Prisoners 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

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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

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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