Analysis of the strategic use of forward contracting in electricity markets

Miguel Vazquez ()

No 2012/13, RSCAS Working Papers from European University Institute

Abstract: Absence of arbitrage is one of the fundamental tools to describe financial markets. The no-arbitrage price of any financial contract represents players’ valuation of the uncertain future income stream that will result from the contract. This reasoning is based on considering future income streams as exogenously defined variables. When spot markets do not behave under the assumption of perfect competition, future income streams might depend on players’ strategies. If this is the case, price differences between the forward and the spot markets do not imply the existence of arbitrage opportunities, as market players cannot take advantage of such differences. The paper will study the forward-spot interaction in the presence of spot market power. It will be shown that, when producers anticipate that forward sales reduce spot price, they can react in the forward market to compensate for the spot price decrease. Hence, players profits are, considering both forward and spot markets, equivalent to the ones obtained in the case where no forward trading is allowed. The paper also develops a multi-period model that considers the role of private information, aimed to represent that past spot prices are signals of the probability of future spot prices. In this context, there is an additional incentive when playing in the spot market, which is associated with the sensitivity of forward prices to past spot decisions. This often results in spot prices equal to the ones obtained in the no-trade case. The policy implications of the previous results will be discussed. Actually, it will be shown that the number of regulatory measures based on forward contracting that can be used to mitigate market power is considerably small.

Keywords: Forward markets; oligopoly; private information (search for similar items in EconPapers)
Date: 2012-03-09
New Economics Papers: this item is included in nep-cta and nep-ene
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Related works:
Working Paper: ANALYSIS OF THE STRATEGIC USE OF FORWARD CONTRACTING IN ELECTRICITY MARKETS (2014)
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