A New Perspective
Loyola de Palacio Series on European Energy Policy
Edited by Jean-Michel Glachant, Dominique Finon and Adrien de Hauteclocque
Chapter 4: Comparison of Long-term Contracts and Vertical Integration in Decentralized Electricity Markets
Richard Meade and Seini O’Connor INTRODUCTION 1 A common view is that electricity sectors should be unbundled and opened to competition, and that in such decentralized (liberalized) markets long-term contracts are necessary to constrain generator market power, elicit competitive entry in retailing and support new generation investment and hence supply security (Boom and Buehler 2006; Vázquez et al. 2002). However, increasing levels of generation ownership by electricity retailers or large electricity customers (and vice versa) – that is, of vertical (re)integration – have been observed in several liberalized systems (Anderson et al. 2007; Gans and Wolak 2008; Hogan and Meade 2007; Thomas 2004). This has led to concerns about market performance, with policy-makers concerned that wholesale and retail competition might decrease, and generation investment and supply security may be under threat (European Commission 2007, Michaels 2006).1 However, problems have emerged with this ‘conventional’ view regarding sector unbundling and competition (Chao et al. 2005; Finon and Perez, 2008; Green 2006). In particular, excessive competitive entry in retailing may threaten the viability of short- and long-term contracts, and thus threaten – rather than promote – generation investment and supply security. Excessive competition can take the form of ‘hit-and-run’ retail entry, for example, under which retail entrants with low entry costs predate customers from existing retailers when the incumbents have signed long-term energy supply contracts at fixed prices but then wholesale energy prices fall. This creates critical ‘hold-up’ risks between retailers and consumers – that is, the risk that customers, facilitated by low switching costs...
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