Contracts and Electricity Pool Prices

Abstract

This paper provides a simple discussion of the interaction between forward contracts for electricity and electricity spot markets. Using a Cournot model of electricity pools, it is demonstrated that generators have a purely strategic incentive to sign forward contracts so as to raise their market share, by lowering price over the elastic portion of their individual demand curves. This, in turn, implies that the existence of the contract market lowers prices in pool markets and hence, over the industry. By mutually committing not to sign contracts, generator profits would be higher. But the existence of the contract market precludes such pre‐commitment. We demonstrate that when there are asymmetries between generators, contracting also allows efficient plants to operate relatively more, lowering the cost structure of the industry. Finally, we consider the effect of contracts on entry and find that it is possible that the existence of a contract market could deter otherwise efficient entry.