Comparison of Long-Term Contracts and Vertical Integration in Decentralised Electricity Markets

Abstract

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 generator hold-up from competitive retail entry, and otherwise supports generation investment and hence supply security. While the reinstatement or retention of retail franchise areas is one possible solution to the problems of contracting, it is arguably unnecessary if there are other system features (such as transmission constraints) impeding retail entry. This is particularly so in systems involving vertical integration, although even then policy makers are confronted with a trade-off between promoting retail competition and facilitating generation investment and supply security, requiring judgement as to the optimal degree of retail market power. While vertical integration is a more natural and self-sustaining solution to electricity sector problems, it too is only a partial solution, leaving complementary roles for spot and long-term contract markets.