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					Incentives for using contractual flexibility provisions in a market environment: the case
                             of the European gas industry

                        Stéphane Tchung-Ming and Olivier Massol
                            IFP, IFP School, Centre Économie et Gestion
                 228-232 Avenue Napoléon Bonaparte, 92852 Rueil-Malmaison, France

   1. Overview

Flexibility – the ability to adapt supply to demand variations, and vice versa (IEA, 2002) – is
an important feature of the technical organization along the gas chain. In the short- and mid-
run, both physical and commercial instruments are likely to be used to provide flexibility to
the system. In particular, LT supply contracts comprise flexibility provisions that allow
buyers to import more or less gas, depending on demand variations.
Flexibility provisions are a central feature of European contracts. Historically, there have been
huge discrepancies for such provisions among suppliers (Parsons, 1986). Those have
sometimes created important tensions in contract (re)negotiations (Estrada et al., 1987).
Indeed, such provisions need being priced, and differences in the base price of contracts might
be explained by differences in contractual flexibilities (Asche et al., 2002). More recent
elements indicate that flexibility provisions still exhibit large dispersions between contracts
(DGComp, 2007).
Although they develop slowly on the Continent, short-term markets can provide flexibility in
the short term. This somehow redistributes cards, in the sense that contracts and markets
become – at least partially – competitors for supplying flexibility to downstream markets.
This was pointed by the EU, which considers that flexibility provisions are in surplus, and
inhibit the development of markets. Questions regarding their future role naturally emerge.

To assess this question, an important prerequisite would be a deeper understanding of the
interactions between contractual flexibility provisions and markets, in the context of the
continental market.

   2. Method

We propose an agent-based modelling framework to analyse the interactions between
flexibility provisions and spot markets. The market structure is considered a bilateral
oligopoly (Smeers, 2008), with strategic gas buyers and producers. A set of bilateral
relationships between sellers and buyers mimics fixed-price LT contracts with flexible
withdrawal bounds. Gas buyers have to satisfy a daily gas demand, and have the choice
between contractual flexibility and the spot market to import gas; besides, they choose the
price they willing to pay for the spot gas. Gas producers are compelled to respond within the
limits of contractual commitments, before they can choose how much of the spare capacity
they wish to commit to the spot market, and at what price. Demand not satisfied under
contractual commitments is transferred to the spot market. Producers and buyers actions are
(price, quantity) bids.
We simulate the convergence towards equilibrium by repeating trading periods. They consist
in clearing the spot market described as a uniform auction. Agents’ behaviors are written off
as by a reinforcement learning rule (Nicolaisen et al, 2003) inspired by (Roth and Erev, 1995;
Erev and Roth, 1998). This rule is characterized by endogenous risk aversion (Oyarzun and
Sarin, 2007).

   3. Results
We performed a comparative statics analysis by increasing the level of flexibility offered in
contracts. Macro-observations indicate that the more flexible contracts are, the lower
exchanged volumes on the spot market will be. Simultaneously, market prices exhibit an
upward tendency. Analysing microbehaviors highlight the following incentives:
   1. Allowing for more flexible contracts incites buyers to report demand from the market
       to the flexible commitments. The marginal utility of larger provisions is decreasing,
       which seems to be an institutional feature rather than behavioral. To test this
       assumption, we introduced Zero-Intelligence traders (see e.g. Micola et al.
       (2008)).This is because (i) risk aversion is a strong motive to secure supplies even if
       this more costly and (ii) the marginal switching cost from the market to flexibility
       might be lower than the inframarginal gain on the spot supplies;
   2. Producing firms react to demand-side behaviors by reducing the intensity of
       competition on the spot market: they exert capacity withholding and bid higher prices.
       But, this also provides an incentive for buyers to turn to flexibility provisions.

   4. Conclusion

Findings indicate that the question of interacting flexibility and spot markets is not just
behavioral, but also an institutional matter in itself. Strategic behaviors can be observed on
both sides of the market, and risk aversion is a strong motive to insure through flexibility.
Thus, contracts (and especially flexibility provisions) and markets should not necessarily be
thought as different in nature, but rather in degree. This might have policy implications, for
example in terms of market design. Moreover, questions like the potential use of such
provisions to exert horizontal foreclosure still need to be assessed.

References

Asche, F., Osmundsen, P., and Tveteras, R. (2002). European market integration for gas ?
volume flexibility and political risk. Energy Economics, 24(3) :249–265.
DG-Competition (2007). DG competition report on energy sector inquiry, available at
http://ec.europa.eu/comm/competition/sectors/energy/inquiry/index.html.
Erev, I. and Roth, A. (1998). Predicting how people play games : reinforcement learning in
experimental games with unique, mixed strategy equilibria. The American Economic Review,
8 :848–881.
Estrada, J., Bergensen, H., Moe, A., and Sydnes, A. (1988). Natural Gas in Europe: markets,
organization and politics. Pinter Publishers, London.
Micola, A. R., Banal-Estanol, A., and Bunn, D. (2008). Incentives and coordination in
vertically related energy markets. Journal of Economic Behavior and Organization, 67 :381–
393.
Nicolaisen, J., Petrov, V., and Tesfatsion, L. (2001). Market power and e ciency in a
computational electricity market with discriminatory double-auction pricing. IEEE
Transactions on Evolutionary Computation, 5 :504–523.
Oyarzun, C. and Sarin, R. (2007). Learning and risk aversion. University of Tewas A&M
Working Paper, available at http ://econweb.tamu.edu/rsarin.
Parsons, J. (1986). Contract flexibility on the european gas market. In Western Europe natural
gas trade : final report.
Roth, A. and Erev, I. (1995). Learning in extensive form games : experimental data and
simple dynamic models in the intermediate run. Games and Economic Behavior, 6 :164–212.

				
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posted:7/19/2011
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