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 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

5. 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

6. 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 Comparison with C&W (2004) DISCLAIMER: My interpretation of earlier work !

7. 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 Solution  comparison with A&V

8. Futures contract = Mutual Insurance against deviations of the futures price F Payment Reduced Pay Off with Perfect arbitrage Financial call option = Insurance contract for prices above strike price S Payment Two Stage Game Contracting Stage Production Stage TIME 1.5 1 2 Generators sell kiLT-contract at a price F Generators learn each other’s contracting position Generators sell qi electricity on spot market Generators payout insurance Pay Off with

9. 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 Futures Contracts for Firm 1 Option Contracts for Firm 1 Second Stage

10. First Stage • Futures • increases number of futures • Market share increases • Spot price goes down • Prisoner’s 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

11. 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

12. 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

13. 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

14. 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