A novel approach for modeling deregulated electricity markets Ofir D. Rubin a,n , Bruce A. Babcock b,c,1 a Department of Agricultural Economics and Management, The Hebrew University of Jerusalem, P.O. Box 12, Rehovot 76100, Israel b Department of Economics, Iowa State University, 578F Heady Hall, Ames, IA 50011-1070, USA c Center for Agricultural and Rural Development (CARD), Iowa State University, Ames, IA 50011-1070, USA article info Article history: Received 21 October 2010 Accepted 4 February 2011 Available online 1 March 2011 Keywords: Deregulated electricity markets Electricity forward premium Oligopoly pricing abstract The theoretical framework developed in this study allows development of a model of deregulated electricity markets that explains two familiar empirical findings; the existence of forward premiums and price-cost markups in the spot market. This is a significant contribution because electricity forward premiums have been previously explained exclusively by the assumptions of perfect competition and risk-averse behavior while spot markups are generally the outcome of a body of literature assuming oligopolistic competition. Our theoretical framework indicates that a certain premium for forward contracting is required for efficient allocation of generation capacity. However, due to the uniqueness of electricity and the design of deregulated electricity markets this premium might be substantially higher than its optimal level. & 2011 Elsevier Ltd. All rights reserved. 1. Introduction Although the electricity sectors in many countries have been deregulated over the last 20 years, there is still no satisfactory explanation for why deregulated electricity markets are character- ized by forward prices that exceed spot prices (Benth et al., 2008; Bessembinder and Lemmon, 2002; Cartea and Villaplana, 2008; Douglas and Popova, 2008; Longstaff and Wang, 2004; Pirrong and Jermakyan, 2008) and why spot prices exceed marginal costs (Borenstein and Bushnell, 1999; Borenstein et al., 2002; Green, 1999; Mansur, 2008; Puller, 2007; Wolfram, 1999). One body of literature explains forward premiums by assuming risk aversion when firms bid for future supplies of electricity. Another body of literature explains marked up prices by the market power of suppliers. Our contribution is a new modeling approach that simultaneously generates forward premiums and price markups. Bessembinder and Lemmon (2002) (henceforth BL, 2002) devel- oped a general equilibrium model where both quantity and price of electricity forward contracts are determined endogenously in an electricity market governed by a two-settlement process (i.e. one market for forwards and one spot market for balancing power in real time). BL (2002) assume that the forward price is based mainly on the expected spot price. They show that the assumption of risk aversion coupled with positive skewness of the expected spot price will generate forward prices that exceed expected spot prices. This explanation for forward premiums relies on risk-averse firms. But firms operating in the electric industry are typically large and well-capitalized. In addition, these firms are continuously in the market for electricity. It is simply not realistic that these firms would have value functions that place less weight on upside income than downside income generated from an hourly or daily market for electricity. It is much more plausible that these firms would operate with an objective of maximizing long-term income. Furthermore, this body of literature ignores the fact that buyers and sellers of electricity are large in the sense that the electric industry is often concentrated therefore raising the possibility that firms will exploit their market power. Prices that exceed marginal costs have been explained using models of oligopolistic competition. The most suitable approach is a Cournot game in which a power supplier acts as a Cournot competitor choosing its own quantity taking the quantities of its rivals as given. Nash equilibrium in this game is reached where all suppliers simultaneously choose profit maximizing quantities. Standard Cour- not models usually overestimate market power of power supplies because they do not consider entry and exit of firms. Since super- normal profits encourage the entry of new firms, incumbents may not be able to exercise market power up to the Cournot equilibrium. Second, being a single-shot game the standard Cournot framework is not suitable to consider the two-settlement process implemented by most deregulated electricity markets. This is limiting because forward contracts are the main pricing tool in these markets. Moreover, the literature suggests that the presence of contracts in a Cournot setting drives suppliers to act more competitively in the spot market and move away from the Cournot equilibrium (Allaz and Vila, 1993). Supply function equilibrium (SFE) is another oligopolistic modeling approach that is frequently used to study electricity Contents lists available at ScienceDirect journal homepage: www.elsevier.com/locate/enpol Energy Policy 0301-4215/$ - see front matter & 2011 Elsevier Ltd. All rights reserved. doi:10.1016/j.enpol.2011.02.040 n Corresponding author. Tel.: +972 8 9489227; fax: +972 8 9466267. E-mail addresses: rubino@agri.huji.ac.il, ofirubin@gmail.com (O.D. Rubin), babcock@iastate.edu (B.A. Babcock). 1 Tel.: +1 515 2946785; fax: +1 515 2946336. Energy Policy 39 (2011) 2711–2721