Comparison of Long‐term Contracts and Vertical Integration in Decentralized Electricity Markets”, Working Paper prepared for

Decentralised electricity systems require effective price and quantity risk management mechanisms, but the nature of such systems poses particular problems for satisfying those requirements. Among these problems are investment hold-up risks rooted in the competition facing both electricity retailers and large industrial firms. Additional problems include those of load profile, information and bargaining mismatches between generators and customers. Significantly, hold-up risks exist not only between retailers and generators, but also affect (e.g. fuel) suppliers upstream of generators. Contracts are one means of addressing such problems, and represent a particular improvement on spot market trading alone. However, we argue that market contracting in electricity systems is a costly approach to addressing hold-up and related problems, and that internal organisation (i.e. vertical integration) is a more efficient alternative, minimising the overall costs of market contracting and ownership. Not only does integration internalise wholesale market risks and market power costs to the integrated firm, thereby reducing their importance, it also reduces the need for and efficacy of regulation to constrain generator market power. It furthermore thins contract markets, reducing the threat of generato