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. 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