The ambiguous effect of contracts on competition and prices in restructured electricity markets

Some argue that contracts reduce the pricing power of firms and hence are beneficial for the efficiency of the market; others explain that they foreclose the market and hence restrict entry of more efficient competitors. We construct a stylized model where two firms, each specializing in some technology, invest in a first stage, contract part of their production in the second stage and sell the rest in the spot market in the third stage. Working with two contracts (peak and off peak), we find cases where the contracts change neither capacity nor prices, where the foreclosing effect can increase investments and reduce prices, and where the opportunity to foreclose the market can incentivize one firm to reduce its investment in order to foreclose the contract market to the other firm and increase pricing power to the detriment of consumers. The model relies on the simplest possible assumptions of imperfect competition (subgame perfect equilibria with Cournot agents). The different results are obtained by changing one single parameter, the height of the off-peak time segment, which can result from different degrees of wind penetration. Our conclusion is also very simple: if it is impossible to characterize the consequences of contracts in a simple example it is not clear how regulators or competition authorities can assess the benefits or drawbacks of contracts in the complexity of real world restructured electricity markets