Should antitrust authorities allow long-term contracts in the energy market?
May 9th, 2009 by Bert Willems, Tilburg UniversityLong-term contracts play an important role in the energy industry, both in the electricity sector and in the gas sector. Gas importers sign long-term take-or-pay contracts with gas exporters, and resell the gas on a long-term basis to gas retailers. Similarly, energy-intensive companies often contract their electrical energy several years ahead.
It is well established in the economics literature that such contracts may have a number of beneficial effects on the functioning of energy markets.
• Contracts allow firms to co-ordinate investments;
• Contracts can be used to hedge the risk faced by firms;
• Firms that use contracts to hedge their market position compete more aggressively in the spot market.
Notwithstanding the potential advantages of long-term contracts for the development of competitive energy markets, regulators and competition authorities have shown some reluctance towards them in recent years. They fear that long-term contracts might be used by incumbent energy firms to foreclose the market, forestall market entry, and diminish competition in the long run.
For instance, the Bundeskartellamt obliged E.ON Ruhrgas in 2006 to decrease the duration of long-term contracts with distributors, and to reduce the gas-volumes tied in those contracts. A similar decision was taken in 2007 by the European Commission concerning Distrigas. (Those cases are discussed more in detail in this blog by Glachant and de Hauteclocque)
In a recent working paper, we study whether regulators should allow an incumbent to sign exclusionary long-term contracts with large energy consumers on the ground that they allow those consumers to hedge their risk. “Should such long-term contracts be tolerated if they are associated with sufficiently large efficiency gains, i.e. those derived from insuring buyers against price volatility?” is the question we ask.
We show that long-term exclusionary contracts – contracts that impose a large penalty on the buyer upon breaching the contract – should not be allowed. Long-term contracts inefficiently deter entry, and prevent the emergence of competitive financial markets, on which energy consumers could have obtained cheap insurance. The financial markets break down because financial investors foresee that the exclusionary contracts will be used to manipulate the energy prices to their disadvantage once they have provided insurance to buyers.
However, in case financial markets are inexistent or illiquid, regulators should allow long-term bilateral contracts offered by the incumbent, as long as they mimic standard financial forward contracts. With a forward contract, upon breaching, the consumer will have to refund the incumbent the market value of the contract, but he will not have to pay any additional penalty. We show that such long-term financial bilateral contracts lead to efficient entry, fully hedge the consumer’s risk and do not hinder the development of financial markets.
To conclude, long-term contracts are an important element of energy markets. They both stimulate investments by reducing uncertainty and make spot markets more competitive. However, long-term contracts signed by a dominant firm should be scrutinized by competition authorities as they might not only lead to market foreclosure but also destroy a potential competitive financial market. Dominant firms should, however, be allowed to sign bilateral financial forward contracts, if financial markets are illiquid, as those contracts do not have a negative impact on entry, but can create significant hedging gains. In either case, the fact that consumers need to hedge their risk cannot be invoked to justify exclusionary clauses in long-term contracts.
Cédric Argenton and Bert Willems, Tilec & CentER, Tilburg University
P.S. For a more in-depth analysis of these issues please see our recent working paper.
For legal aspects of contracts in the energy market see also the posts by G. Bellantuono. on the role of long term contracts in energy markets
and on whether firms should be allowed to revise long term contracts .
May 19th, 2009 at 1:03 pm
The contribution of Bert Willems sums up his work with Cedric Argenton on long term contracts, hedging and foreclusion. This contribution is relevant as long term contracts are at the center of both political and academic debates.
Cedric and Bert analyze risk hedging and foreclusion by long term contracts. The main problem of long term contracts is related to exclusionary clauses which can be used to foreclose an efficient entry. The European competition authorities are well aware of that issue and are very suspicious toward dominant firm long term contracts and particularly exclusionary ones.
However, the academic debate is still vivid on long term contract, and there is no clear consensus and standard model to analyze them – as there is for merger with trade-off between market power increase and efficiency gains. There is a lot we do not understand and particularly on their effect on investment, An illustration of the debate among economists is the criticism made by Spier and Winston (1997) on the work of Aghion and Bolton (1987). As Argenton and Willems use the same framework as Aghion and Bolton this criticism is worth mentioning. Aghion and Bolton (1987) assume that the incumbent firm cannot negotiate with the entrant. If it were the case, the incumbent firm would buy electricty to the entrant to fulfill its contractual obligation if the entrant is more efficient than the incumbent. In that case the exclusionary clause no longer impedes economic efficiency.
Aghion, Philippe and Patrick Bolton (1987), “Contracts as a Barrier to Entry,” American
Economic Review, 77 (3), pp.388-401.
Spier, Kathy E. and Michael D.Whinston (1995), “On the Efficiency of Privately Stipulated
Damages for Breach of Contract: Entry Barriers, Reliance, and Renegotiation,” RAND
Journal of Economics , 26 (2), pp.180-202.
However
July 29th, 2009 at 11:33 am
This debate seems to go round in circles – and will continue do so. The problem is the uncertainty regarding climate change, energy security and energy demand. We are in a real boiling pot at this time.
September 17th, 2009 at 6:33 pm
Guy Meunier rightly underlines the fact that in industrial economics results tend to be dependent on particular assumptions concerning market structure or market interaction. Nevertheless, modeling is not an arbitrary exercise and assumptions can be reasonably attacked and defended on the basis of their degree of usefulness or realism in capturing relevant features of the world subject to analysis.
There might be no consensus among economists as regards the treatment that vertical restraints should receive under competition policy but we feel it is a bit harsh to state that there are no standard models.
When it comes to exclusivity contracts, two main “theories of harm” are regularly used in the academic and policy literature. The first one stems from the Aghion and Bolton (1987) article and focuses on the possibility for existing market participants to use exclusivity contracts as a way to force the entrant to lower its price (thus generating surplus for the parties but making entry less profitable). The second theory is associated with the “naked exclusion” scenario first put forward by Ramseyer, Rasmusen and Wiley (1990). In this scenario, the entrant needs the patronage of several big buyers in order to recover its entry cost. The incumbent can play on the coordination problems of those buyers so as to induce enough of them to sign an exclusivity contract that effectively deters entry.
There are two ways to look at the objection raised by Guy as regards the set-up of Aghion and Bolton (1987):
First, it is true that the entrant does not sit at the negotiation table! If he could make an offer at the same time as the incumbent, or if all parties could sit and renegotiate post-entry under full information, only efficient outcomes would be reached. This is a version of the Coase theorem and it is actually at the core of the Chicago critique of antitrust. However, costless, universal bargaining is a strong assumption. If true, there would be no need to go beyong cartel-busting in the field of competition policy, as article 82 abuses would not arise, only efficient outcomes! Post-Chicago models precisely stress that incumbents may have a first-mover advantage and that post-entry various obstacles (including the very existence of competition policy) may prevent the incumbent and the entrant from striking a deal.
Second, Spier and Whinston (1995) have stressed that a contract may actually be the wrong instrument for a contracting pair to commit to inefficient outcomes. In all jurisdictions, contracts are typically renegotiable and indeed, post-entry, if the cost of the entrant is observable, the incumbent and the buyer have an incentive to undo their exclusivity contract and accept the offer of the entrant whenever the latter can produce at a cheaper cost than the incumbent. Yet, if the cost of the entrant is not observable, this incentive disappears. Moreover, internal agency problems may actually restore the commitment value of contracts by making it costly for a firm to rengotiate its contracts ex-post. As a matter of fact, in most firms, the sales department and the legal department are separate and face very different incentives!
All in all, we believe that Guy’s criticims does not invalidate the relevance of the class of models to which our paper belongs but it is a useful reminder that “harm” will not occur whenever market participants have ways to adjust or go around the situation created by the existence of long-term contracts. Hence, competition authorities should always check that the alleged victim of an exclusionary practice indeed had no way to devise an effective counter-strategy (making an early, attractive offer to buyers, negotiating market access with existing sellers, etc) in order to prove the infringement.