Bargaining Power in the Natural Gas Market: Long Term
Contracts and Investment in Alternative Supply
8,148 words
Wei Zhang
(ANR 897837)
Master Thesis,
MSc. In International Economics and Finance
Supervisor: dr. ir. Bert Willems
September, 2010
1 Introduction ............................................................................................................... 3
2 Literature Review: .................................................................................................... 4
2.1 Long term contract ............................................................................................ 4
2.2 Bargaining power .............................................................................................. 5
2.3 Renewable Energy ............................................................................................ 7
3 The Model .................................................................................................................. 9
3.1 Technology of gas ............................................................................................. 9
3.2 Players ............................................................................................................. 10
3.3 Timing of the game and the action they take .................................................. 11
3.4 The best choice of investment: from a view of a social planner in a perfectly
competitive market................................................................................................ 12
3.5 Scenario........................................................................................................... 13
4 Solving Models ........................................................................................................ 13
4.1 Scenario one: No long term contract .............................................................. 13
4.1.1 The short term gas trading stage ........................................................... 13
4.1.2 The investment stage ............................................................................. 15
4.1.3 Summing up .......................................................................................... 16
4.2 Scenario two: Long term contract reached ..................................................... 17
4.2.1 The short term gas trading stage ........................................................... 17
4.2.2 Investment Stage ................................................................................... 19
4.2.3 Negotiating Stage .................................................................................. 20
4.2.4 Summing up .......................................................................................... 21
4.3 the elasticity ............................................................................................. 22
5 Numerical Example ................................................................................................ 22
6 Conclusion ............................................................................................................... 24
Reference..................................................................................................................... 26
2
1 Introduction
Gas has been an important source in the European Union because it is used in several
economic sectors. Almost 60% of the gas required in the European Union is imported
since the gas produced in European countries can not satisfy the need of industries.
The consumption of gas comes from two aspects: long term contract and spot market.
The most popular form of long term contracts is a take-or-pay contract. This kind of
long term contract usually concludes two parts: the first one is a ―Take or pay‖ clause
which means the buyer will pay for a certain volume of gas per year, whether the
buyer actually uses or not; the second one is to index the price of gas to some relative
energy substitute or basket of substitutes such as oil derivatives.
Since the consumption of gas has been increasing considerably in recent years, the
discussion about the long term contract price making has been popular for a long time.
Because the gas market is not competitive, the buyer power and the seller power are
considered and discussed a lot in many literatures about long term contract pricing
making in the gas market.
The seller power is caused by the lack of competition among main exporters—Russia
has 40 percent of the total import, Norway 23 percent and Algeria 17 percent.
Essentially, the reason for seller power is uneven natural distribution of gas resources
in the world. Meanwhile, the buyer power is argued to be mainly by big importing
companies. However, the establishment of the Gas Exporting Countries Forum further
strengthens the seller power since one of the Gas Exporting Countries Forum is to
―identify and promote measures and processes necessary to ensure that Member
Countries derive the most value from their gas resources, taking into consideration the
nature of gas as a non-renewable source of energy‖¹.
Renewable energy sources are introduced by the European Union not only for
environmental protection reasons (the use of gas can worsen the problem of global
warming) but also to balance the increasing seller power
On the other hand, spot market plays a more and more important role in European
Union gas supply. Started in the mid 1990s, short term trading developed rapidly
when the UK gas market was deregulated in 1998. A gas trading hub is established in
___________________________
¹See website of the Gas Exporting Countries Forum: http://www.gecforum.org/
3
Zeebrugge in Belgium. Gas trade is also developing in other locations like
Aachen-Eynatten and Lampertheim in Germany, or Zelzate, between Belgium and the
Netherlands.
There is a lot of literature about the long term contract price making. Neuhoff and
Hirschhausen (2005) argued that long term contract can decrease the price of gas.
Kupper (2010) made a two stages model to support that substitutions of gas can be
used to lower the gas price on the spot market. However, how substitutions affect long
term contract price in gas market remains unknown. This paper has two aims: (1)
combining the long term price making model with the three stages model to see how
the optional choice in renewable energy can affect the price and quantity of long term
gas contracts and of short term gas market; (2) is the choice of investment in
renewable energy the reason for the different elasticity between the short term market
and long term market?
This paper is structured in the following way: chapter 2 reviews previous literature
about long term contracts in the gas market and strategic investment of renewable
energy; chapter 3 introduces the set up of the models; in chapter 4 we will solve the
models; chapter 5 shows the numerical results; the final chapter is the conclusion.
2 Literature Review:
2.1 Long term contract
There is a lot of literature discussing different factors of long term contracts. The
European Commission (2006) points out that long-term supply contracts are used as
obstacles by incumbents of the gas market (both producers and importers) to make it
difficult for new entrants to access gas on the upstream markets. Following this view,
the European Commission concludes that the long term contracts slows down the
market integration.
The European Commission also argues that when linked to the oil derivatives price
the long term contract prices do not reflect the changes in the supply and demand of
gas market. This situation becomes worse when the indexation in long term contracts
is linked to variables calculated with trailing averages. Hubbard and Weiner (1991)
conclude that efficiency can be achieved if the price indexation provisions are taken
since it links prices with changing demand conditions. Parsons(1986) shows that the
gas prices will move in the same parallel way with substitute’s prices under the
4
assumption of a perfect competitive market. However, Golombek and Hoel (1987)
point out that a negative relation should exist between the oil price and the gas price
for an efficient contract when the gas importing country or the gas exporting country
is risk averse and none of them is a risk lover.
When mentioned the take-or-pay clause of the long term contract, the European
Commission argues that the need for the seller to buy and sell on gas trading hubs is
limited by the take or pay obligations. The European Commission further points out
that this limitation causes low liquidity, and hence increases the risks of trading by
reducing the chances of finding an acceptable counter-party when a trader needs to
close a position. However, many papers give positive comments for take-or-pay
obligations. Masten (1988) concludes that the price is set by equalizing the expected
marginal revenue and marginal cost under take-or-pay provisions. Crocker
Masten
(1985)
and
Mulherin
and
(1986) show a negative relation between the
take-or-pay requirements and the number of pipelines serving a field and a positive
relation between the take-or-pay requirements and the number of independent sellers
located in a field by empirical evidence, which is used to support the cost of
transaction hypothesis.
Valencia Marin (2009) compares the efficiency of four situations: no contract, the
complete contract, the take or pay contract and a forward contract. By comparing the
social welfare and the utility of the buyers and sellers, she draws the conclusion that
the complete contract has the highest expected utility for the seller.
Creti Bertand Villeneuve (2003) show that the European Union position on long term
contracting mixes up contract duration and flexibility by analyzing the role of
take-or-pay clauses and price indexation rules. They also discuss the theoretical and
empirical research linked to American experience and whether regulation distorts
optimal contract duration.
2.2 Bargaining power
Galbraith (1952) introduced the concept of ―countervailing power‖ which stands for
the counterbalance power of large buyers in concentrated downstream markets against
the supplier power. Following his theory, several authors evaluate the ability of large
buyers to lower the product price, mainly focusing on the size of buyers, the mode of
competition and the number of retailers.
In a model presented by Snyder (1996), one buyer can gain advantage over the sellers
5
by purchasing all of unfilled orders at once. Besides, the author concluded that the
growth of buyer will affect the profits of all buyers in the market. For example, all
buyers are benefiting from lower prices if a buyer grows through a merger with
unchanged market size, meanwhile all buyers pay higher prices if a buyer grows
through addition.
Von Ungern-Sternberg (1996) uses a two-stage game model to study the predictions of
the theory of countervailing power. In the first stage, one single producer bargains
with N retailers about the whole sole price. Nash bargaining solution is achieved in
the first stage. The author concludes that if the producer’s bargaining power increases
or his outside option improves the equilibrium wholesale price rises. In the second
stage, the retailers compete with each other and the price is achieved either under
Cournot competition or perfect competition among retailers. Von Ungern-Sternberg
(1996) shows that retailers can benefit from lower price if the number of retailers
decreases in case of perfect competition, which proves the hypothesis of
countervailing power. However,
when the number of retailers decreases in Cournot
competition, the result shows that the lower intensity of competition has negative
effects which is always outweigh the positive effects of countervailing power.
Dobson and Waterson (1997) introduce a two stage complete information game to
show the effects of increased retail concentration on consumer prices and welfare. In
first stage, an input supplier negotiates transfer price with each retailers. In the second
stage, the retailers set prices to consumers by competing with each other. The result
shows that the substitutability of the retailers’ services plays an important role for the
profit of supplier. If the retailers’ service is very close substitutes, higher competition
among retailers can decrease the price and the profit of suppliers while social welfare
increases. However, the supplier could protect its profit by dealing only one retailer at
one time.
Ruffle (2000) points out that when two sellers simultaneously choose a price and a
quantity for buyers to choose which one to purchase, the buyers also have the ability
to make sellers lower the prices. By forgoing profitable purchases as part of long-term
strategies, the buyers gain market power. Six years later, Ruffle and Engle-Warwick
(2006) further researched the ability of a small number of buyers to influence the
pricing of a monopolist by doing experiments. The result shows that a smaller number
of buyers can make the price lower in the market since the monopolist seller is afraid
of provoking costly withholding.
6
Inderst and Wey (2000) point out that retailers have more incentive to get bargaining
power by merger with increasing unit costs, meanwhile suppliers have more incentive
to merger if goods are substitutes. This result comes from the assumption that demand
is independent at all retailers by using Nash bargaining solution. Inderst (2005)
concludes that the size of the buyer can cause different results for price with different
number of sellers. If there is only one seller, a large buyer gets low purchasing price
per unit while small buyers pay lower price if there are many sellers under the
assumption that the sellers have strictly convex costs.
Neuhoff and Hirschhausen (2005) argued that long term contracts can benefit both
producers and consumers. The main idea is that through the model based on the
assumption that the long-run demand elasticity is significantly lower than the
short-run elasticity, they showed both strategic producers and consumers benefit from
the lower prices and larger market volume.
They started the models of long term and short term demand with the assumption that
short term demand had different elasticity with long term demand. They used a two
stages model: the producers are oligopoly and they decided on the quantity of long
term then short term supply was also decided by taking the long term supply out of
the whole supply while the consumers decided the investment in long term equipment
and the expected demand. The core part of the model is that the authors added a ―r‖
on demand slope to show that short term demand is more price responsive. Based on
the rule that the producers would maximize their profit, they showed the result that if
the elasticity was significantly different between long term demand and short term
demand (the demand slope scaled factor exceeded 4.8), both the consumers and the
producers would benefit from the long term contracts since the consumers benefit
from lower price and the producers benefit from large demand of gas.
There is one thing to be discussed in the paper of Neuhoff and Hirschhausen (2005):
they only showed the result that both consumers and producers would benefit from
long term contracts, if there was different elasticity between short term demand and
long term demand, but they didn’t explain where the different elasticity comes from.
Why in the short term market is the demand more price sensitive? It could be the
other choices which leads this different elasticity in different gas market.
2.3 Renewable Energy
The Commission of the European Communities published an article in 2007 to
7
introduce the long term vision for renewable energy sources in the EU. The paper first
shows the recent situation of EU renewable energy, and explains the different
achievements in different regimes. The paper also introduces a possible way to
achieve an increased role for renewable energy sources. The paper states some
principles including a framework based on long term mandatory targets, increased
flexibility in target setting across sectors and so on. Moreover, the paper gave a brief
overview of the impact assessment of the renewable energies. It is very clear that the
renewable energy sources contribute a lot to solving the climate change problem since
renewable energies cause low even zero greenhouse gas emissions. Besides, the
security of energy supply can be strengthen by increasing the renewable energy
penetration of the total energy supply. The reason is renewable energy can increase
the share of domestically produced energy, diversify the fuel mix, diversify the
sources of energy imports and increase the proportion of energy obtained from
politically stable regions. Mentioning the cost and competitiveness factor, this paper
gave a general view that the significant difference among renewable sources leads to
the distortion in favour of non renewable energy sources although the cost of
renewable energy sources decreased over the last 20 years. The international prices of
conventional energy sources like oil together with finance mix, the technology
choices made and the degree of competition in renewable sectors will affect the result
whether the target can be achieved.
Kupper (2010) discusses whether the decision of European Union to become a low
carbon economy by investing in renewable energy, could also be a strategic solution
of decreasing seller power and protecting the European economy from deeply relying
on the energy imports.
He introduces a two stages model that starts with simple situation. He assumed that
only one producer and one supplier shared the profit that the producer got from
price-taking consumers. The importer could make product from two technologies:
no-capacity-limited gas which was imported after paying a sunk investment cost and
capacity-limited energy with investment cost. With complete information, the first
stage of the model is the investment stage and the second stage is bargaining stage.
Started with linear cost function and demand function, the author introduced Shapley
value to solve the problem of players sharing the joint payoff in bargaining stage and
distinguished the case that the marginal cost of gas is bigger than the new technology
from the case that marginal cost of gas is smaller than the new technology in the
8
investment stage. The result shows that unused local capacity can lower the gas price
as a threatening role since under linear cost assumption the local technology turns to
be either fully used or not sued at all.
The author then used non-linear cost function assumption that the supply cost of gas is
convex instead of the linear cost function assumption in the beginning. The results
remain the same with the situation of the linear cost function which is although some
capacity remains unused it still makes the gas prices decrease and the importer and
exporter share the surplus equally. The author also used numerical illustration to show
different effects of different alternative technologies used by importers. In the
numerical illustration, it turns out that importers had the largest gains by investing
nuclear. Taking the government which aims to improve the social welfare of the
importing county in to account, the author showed that through tax and subsidy
instrument the government can affect the decision of the importer which is showed by
numerical illustration later. The author further described the situation of more
importers. Except the investment is likely to be suboptimal, the result that investing in
new technology will reduce the gas price remains the same.
There are some questions to be discussed for the paper of Kupper (2010). First of all,
the assumption that the investment cost of gas was sunk underestimates the incentive
of importer to invest in new technology. Secondly one exporter assumption is
restrictive as there are three main exporter countries. Even in the future the market
power of the exporters will be strengthen through the establishment of the Gas
Exporting Countries Forum, there is still limited competition among export countries.
Finally, this paper focuses on the effect of investment in new technology on short term
market. But how the investment in new technology affects the long term contracts
price remains unknown. The choice of investing in renewable energy could just be a
strategic threaten for increasing the buyer bargaining power in the negotiation stage.
After getting a reasonably lower price for long term gas contracts, the importer might
finally not invest in any local technology.
3 The Model
3.1 Technology of gas
In the early 1950s, natural gas was seen as a by-product of the exploitation of oil. The
use of gas was limited and the transportation and the storage costs were high in the
9
beginning. The situation had not been changed until the technology of liquefied
natural gas (LNG) was invented. The GIIGNL introduces the technology of LNG in
their paper which shows that the LNG Process Chain includes the Extraction,
Processing, Liquefaction, Transport, Storage, Regasification and Distribution to
consumers of LNG. Extraction of natural gas produces feed gas then cleaning feed gas
by separating and removing various extraneous compounds is done during the
processing of LNG. The next step, liquefaction of the natural gas, is achieved by
refrigeration down to approximately -162℃. After transporting the LNG over long
distances by sea in ships or over shorter distances by trucks, natural gas is sent out to
consumers through a pipeline distribution network. The LNG Process chain is proved
to be very safe and is widely used in the world. But the absence of exclusive LNG
trading hubs given the high costs of storing LNG limits the development of LNG
market.
3.2 Players
We propose a simplified model of bilateral negotiation in which two players are
considered: a domestic firm that imports gas to produce electricity and a foreign
exporter who exports gas. In the model, the domestic firm which is referred as
producer and the foreign exporter will behave with the market power since there is
only one exporter and one importer. But in the beginning we will also consider the
situation of no market power. The price and investment decision will be discussed in a
perfect competition market from a social planner’s view.
In our model, we assume that the electricity generating company is a monopolist in
the domestic market. To produce electricity, the domestic producer can use two
technologies: one based on gas imported from the exporter both in short term and long
term, the other using a fuel either locally available or geographically unconcentrated.
The latter technology can refer to renewable energy. We will call the technology the
producer can invest in ―local‖ technology throughout the whole paper. The total
demand of gas for the domestic firm comes from two parts--short term demand and
long term demand or only the short term demand in case that there is no long term gas
contract reached.
There is only one exporter in our model since current foreign gas supply to the
European Union is concentrated and the concentration is even more given the truth
that a further more concentrated organization will be established. The exporter
10
supplies the gas both under long term contract a longer term contract or long term
contracts and in short term market in a short term market or the short term market.
3.3 Timing of the game and the action they take
We begin by considering the interaction between the producer and the exporter and do
not consider any environmental damage. We also assume that the information is
complete hence there are no problems of uncertainty and asymmetric information.
There are three stages in the model: The first stage is the negotiating stage. In this
stage, the producer will negotiate the quantity and price he needs for same as before
long term gas contract. The second stage is the investment stage, in this stage the
producer will decide whether to invest in the new technology and how much to invest
if he decides to build new capacities. The third stage is the short term gas trading
stage. In this stage the producer will buy the quantity he needs from the short term gas
market.
We will start from the third stage of the game. Then back to the second, then back to
the first stage.
There are three situations that the quantity the producer needs, denotes by Q, comes
from: If there is no long term gas contract reached in the negotiating stage, all
quantity comes from the local technology he invests, denotes by QS , and from short
term market trading, denotes by QST ; If there is a long term gas contract reached in
the first stage and the producer decides to invest in local technology, the quantity
comes from the local technology he invests, from short term market trading and from
the long term gas contract, denoted by QLT ; It’s also possible that the producer decides
not to invest in local technology, then the quantity only comes from long term gas
contracts and from short term market trading. In a formula, it can be expressed
as Q QST
QLT
QS . If the producer invests in new capacity to produce local
energy, he will have a total cost k per unit of capacity which includes all costs per unit
of capacity such as fixed cost and marginal cost.
Let's assume the exporter faces a linear demand function with a demand intercept A
and demand slope b, which can be expressed as follows:
Q
A b*P
(4.1)
P denotes price in general. The cost function of the exporter is linear and expressed
with the following expression:
11
Ce
c *Q
(4.2)
Here the per unit cost c includes the extraction and the transportation cost. We see the
capital cost of importing gas is sunk since the producer has capacities based on the gas
technology already installed.
The quantity that the producer can supply is given by the following expression:
Qs
*P
Here
denotes the capacity the producer supplies after he invests. This function
(4.3)
describes the quantity the producer supplies based on the price of the market. It shows
that the higher price is in the market, the higher quantity the producer will produce by
new technology.
To build the new local technology, the producer needs to invest k per capacity. Since
the whole capacity would be
Cs
, the total cost CS would be:
*k
(4.4)
First we will see how much the social planner will invest in local technology in a
perfectly competitive market.
3.4 The best choice of investment: from a view of
a social planner in a perfectly
competitive market
In a perfectly competitive market, the price is equal to the marginal cost of gas that
the producer imports, which means P=c. A social planner will decide how much to
invest in local technology.
After Putting P=c into expression (4.3), we get the new expression of quantity
supplied by local technology:
Qs
*c
(4.5)
The social planner will try to maximize the social welfare—here is only the profit of
producer:
MAX (
* c2
2
k* )
We get the corner solution of (4.6), which is as long as c 2
(4.6)
2k the social planner will
invest the local technology and the quantity the producer use will fully come from the
local technology. Keep this result in mind, later we will see the different result when
12
there exists market power.
3.5 Scenario
There are two scenario in our model, the first one is that there is no long term gas
contract reached in the negotiating stage. We first will see the short term gas trading
decision about the price and quantity of gas. Then we will move to the investment
stage to see the investment decision. The second scenario shows the situation that
there is a long term gas contract reached in the negotiating stage. There are different
decisions of the short term gas market and investment in local technology affected by
the quantity of the long term gas contract. We will also see decisions of long term gas
contract about the price and quantity.
4 Solving Models
We start from the scenario one.
4.1 Scenario one: No long term contract
In this situation, there is no long term gas contract reached in the first stage. The
producer has already invested in substitutions in the second stage and can provide
other energy sources to produce electricity by themselves. But the producer still needs
to buy gas in the short term market and the producer is price taker in the short term
gas trading stage.
4.1.1 The short term gas trading stage
The fact that there is no long term contract means the total demand Q comes from the
short term market and the new local technology. Hence, the exporter only faces the
short term demand, which is described as follows:
QST
Q Qs
A b * PST
* PST
Simplifying this expression, we get:
QST
A (b
) * PST
(4.7)
Since we assume there is only one exporter, the exporter is monopolist. Thus the
exporter will maximize his profit to determine the gas quantity and price in the short
term market.
The profit of the exporter is:
13
PST * QST
e
c * QST
(4.8)
Maximize the profit of the exporter by differentiating QST :
PST
* QST
QST
e
QST
PST
c
0
(4.9)
Calculating the result of (4.9), we can get the exporter-maximum-profit quantity
which is expressed by a function of
A c * (b
)
QST
2
2
in the short term gas market:
(4.10)
Substituting the expression (4.10) in the short term demand function (4.7), we get the
short term gas market price expressed by a function of
PST
A
2(b
:
c
2
)
(4.11)
As we can observe from the expressions of short term gas quantity and price, the
investment item
plays an important role in short term gas quantity and price. The
bigger the value of
is, the smaller gas quantity the producer needs in the short
term market and the lower the gas price in short term market.
The result is reasonable in the real world. It is obvious that in reality if the producer
invests more in local technology and can supply more by himself, then the producer
will need less in the short term market and also the price will reduce. We can see it
from the figure 1 from a supply-demand aspect:
Figure 1
P
D
S
D
P*
*0
0
P
Q
Q*
Q
14
When the demand is less, the price and the quantity both will become smaller.
Therefore, the more local technology can supply the energy to the producer, the lower
the price the producer can get. However, the producer must balance this low price
with the increased investment cost. This is showed below.
4.1.2 The investment stage
The previous stage shows that the producer gets a better price if he invests in local
technology. However, this result is costly. The producer must decide how much to
invest in local technology to maximize his profit. In this stage, we will discuss the
investment decision made by producer.
Since the producer has already known that there is no long term gas contract in the
first stage, he decides to invest in new local technology. To determine the investment
of the producer, we must calculate his profit.
The profit of producer comes from two parts:
The first part is the surplus from the energy of local technology the producer invests,
which can be described as follows:
1
s1
PQs
2
(4.12)
Substituting the expression(4.3) into (4.12), we can get the first part??? producer
surplus can be rewritten as follows:
s1
Qs2
2
s1
( * PST ) 2
2
2
* PST2
(4.13)
The second part is the surplus from the gas of short term market trading the producer
buys. We calculate it as follows:
s2
Q2
2b
(4.14)
Substituting the expression(4.1) into (4.14), we can get the first part producer surplus
can be rewritten as follows:
s2
( A b * PST ) 2
2b
(4.15)
15
The total profit the producer can get is the sum of these two parts:
s
s1
s2 C s
(4.16)
The producer will try to maximize his profit, which is the total surplus in this case, to
determine the his investment in new technology. This is described as follows:
s
0
By differentiating the quantity item
of each expression of producer surplus, we get
the following expression:
s
PST2
2
* PST *
P ST
PST
b * PST *
PST
k
0
(4.17)
Substituting the expression (4.11) into (4.17) then simplifying it, we get the optimal
choice of investment in new local technology for the producer:
3 A2
8k c 2
b
(4.18)
As shown in (4.18), the investment has a positive relation with c--the per unit cost of
importing gas. It also fits the reality very well because when the per unit cost of
importing gas is higher, the producer has more incentive to invest the new technology.
The cost of building a new local technology has a negative effect on the capacity. If
the cost of building a new local generation is higher, the investment in new local
technology would be lower. We can also see that the investment has a negative
relation with the price elasticity item b. The bigger the elasticity is, the smaller the
investment is. It is obvious that if the demand is very sensitive to the price, the
producer will lower his investment.
Besides, we can see that as long as c 2
8k , the producer will invest in local
technology. Compared to the result of the first choice from a social planner's view, we
can see that even the space c 2
2k , the producer will still invest in the local
technology for bargaining power. On the contrary, the producer will not invest in local
technology if space c 2
8k while the social planner will still invest in local
technology under this situation. This is caused by the sellers market power.
As we know we assume that there is no long term gas contract reached in the first
stage. So there is no need to discuss the negotiation stage.
4.1.3 Summing up
In this Scenario there is no long term gas contract reached in the negotiation stage, the
16
producer decides to invest local new technology and supply part of the energy himself.
We should notice that during the time that the new technology is built, the producer is
still getting the gas from the long term gas contract he signed before because the
duration of the long term contract is usually fifteen years or more. As we can see from
the result, the optimal investment choice for the producer to build the new local
technology is affected by the per unit gas cost, cost of building a new generation and
the demand elasticity. If the demand is very sensitive to the price, then the producer
will invest less because the uncertainty of demand. Also if the per unit cost of gas is
high, the producer has more incentive to invest to reduce his energy cost. The high
investment cost will lower the incentive to invest in a new local technology. Then in
the short term gas market, the exporter will charge a lower price if the producer can
supply more energy himself and the quantity the exporter sold in the market also
decrease with increasing energy made by local new technology. In the end, compared
to the investment decision made by the social planner in a perfectly competitive
market, market power distorts the investment decision not only because the buyer
wants to gain bargaining power but also because the market power owned by the
seller.
4.2 Scenario two: Long term contract reached
In this situation, the long term gas contract is signed in the first stage. The producer
also invested in substitutes in the second stage and can provide other energy sources
to produce electricity by themselves. Moreover the producer needs to buy gas in the
short term market and the producer is price taker in the short term gas trading stage.
4.2.1 The short term gas trading stage
The exporter faces the same linear demand function (4.1) and has the same linear cost
function (4.2). The producer also has the same supply function for new energy
resource as (4.3).
Since there is a long term contract reached in the first stage, the total demand Q now
is met from three parts: long term gas contract, short term market and the new local
technology. In this stage, we take the quantity and price of gas in long term gas
contract as given since the producer and the exporter have already settled them down
by negotiating in the first stage.
Now the demand the exporter faces in short term gas market is :
17
QST
Q Qs QLT
A b * PST
* PST
QLT
Simplifying this expression we get:
QST
A (b
) * PST
QLT
(4.19)
The exporter will maximize his profit to determine the gas quantity and price in short
term market.
The profit of exporter now is:
PST * QST
e
PLT * QLT
c * (QST
QLT )
(4.20)
Maximizze the profit of the exporter by differentiating QST , we can get:
e
QST
e
QST
0
A QLT
b
2QST
c
0
(4.21)
Calculating (4.21), we can get the exporter-maximum-profit quantity in the short term
gas market which is expressed by a function of
contract QLT :
A QLT
QST
2
c * (b
2
and the quantity of long term gas
)
(4.22)
Substituting the expression (4.22) in the short term demand function (4.19), we get the
short term gas market price expressed by a function of
PST
A QLT
2(b
)
c
2
and QLT :
(4.23)
As shown in (4.22), the quantity for the exporter to make the optimal profit in the
short term market is affected by the quantity of the long term gas contract and the
investment in the new local technology. The more quantity supplied by the long term
gas contract, the less quantity will be in short term gas market. Meanwhile, the more
investment the producer invests in local technology, the smaller the quantity will be in
short term gas market.
The equation (4.23) shows that the price of the short term gas market has a negative
relation with the quantity supplied by the long term gas contract and the investment in
new local technology. It is very usual that based on demand-supply theory, the lower
demand will cause lower equilibrium quantity and price. Referring to this case, the
18
quantity supplied by the long term gas contract and by new local technology will
cause a lower demand hence leads to a lower equilibrium quantity and price in the
short term market.
4.2.2 Investment Stage
The previous stage shows that the producer gets a better price in the short term gas
market if he invests in local technology and signs a long term gas contract. However,
the producer still needs to decide how much to invest in local technology to maximize
his profit.
The cost function of the producer remains the same with (4.4)
To determine the investment of producer, we must calculate his profit. The profit of
the producer still comes from two parts:
The first parts remains the same with the situation that there is no long term contract
reached in the first stage, which is equation (4.13); the second part is from the gas he
buys from both long term contract and short term gas trading, but still can be
described as function (4.15), notice that the price here has a different expression from
situation1. Therefore, the total profit can still be described as (4.16)
Maximizing the total profit of producer by differentiating the quantity item
we can
get:
s
s
0
PST2
2
* PST *
P ST
PST
b * PST *
PST
k
0
(4.24)
Substituting the expression (4.23) into (4.24) then simplifying it, we get the optimal
choice of investment in new local technology for a producer which can be expressed
as follows:
3( A QLT ) 2
8k c 2
b
(4.25)
As we can see from expression (4.25), the investment is affected by the quantity
supplied by the long term gas contract, the per unit cost of gas and the elasticity.
The more quantity the producer gets from long term gas contract, the less he will
invest in new local technology. Meanwhile, the effect of per unit cost of gas, of
investment cost and of the elasticity on investment in new local technology remains
19
the same with Scenario one.
Substituting (4.24) into (4.22), we can get the new expression of PST :
PST
1 8k c 2
*
2
3
c
2
(4.26)
As shown in (4.26), the investment cost k and the per unit cost of gas have a positive
effect on the short time gas price. The higher investment cost k makes the short term
gas price higher since the higher investment cost decreases the investment in
substitutions hence increases the demand of gas in the short term market. Besides, it is
obvious that the higher per unit cost of gas can lead to a higher gas price in the short
term market.
Substituting (4.25) into (4.22), we can get the new expression of QST :
QST
(1 c *
3
8k c
2
)*
A QLT
2
(4.26)
As can be shown in (4.26), the investment cost k has a positive relation with short
term gas quantity while the quantity of the long term gas contract and the per unit cost
of gas have a negative effect on the short term gas quantity.
4.2.3 Negotiating Stage
In the investment stage, we get the expression of optimal investment in substitutes for
the producer. Now we turn to the negotiating stage which is also the first stage of the
whole game. We assume that it is a perfect arbitrage situation. Under this assumption,
the producer is an arbitrager who will sign the long term contract when the gas price
of the long term contract is equal to the price of the short term market. Otherwise, the
producer will only buy gas from the lower price situation—either only from short
term gas market or from long term gas contract.
In this situation, the long term gas price is:
PLT
PST
A QLT
2(b
)
c
2
1
8k c 2
*
2
3
c
2
(4.27)
Now we turn to the decision of the exporter for gas quantity of long term contract.
The exporter will try to maximize his profit, which is:
e
P ST *QST
PLT * QLT
c * (QST
QLT )
(4.28)
Substituting (4.26) and (4.27) into (4.22), we can get the new expression:
20
e
1
8k c 2
( *
2
3
c * ((1 c *
c
3
A QLT
) * (1 c *
)*
2
2
8k c
2
3
8k c
2
)*
A QLT
2
1
8k c 2
( *
2
3
c
) * QLT
2
QLT )
Simplifying the function above, we get the expression as follows:
e
A
8k c 2
*(
4
3
c) * (1 c *
3
8k c
)
2
QLT
8k c 2
*(
4
3
c) * (1 c *
3
8k c 2
)
(4.29)
We can see from (4.29), to maximize the profit the exporter should supply the quantity
of gas as much as the producer needs under the long term gas contract.
4.2.4 Summing up
In this scenario, we consider the situation that there is a long term gas contract
reached in the negotiating stage. Compared to the result we get in case that there is no
long term gas contract reached in negotiating stage, the quantity of gas traded in the
short term market is not only affected by the investment in local new technology but
also affected by the quantity of long term gas contract. The quantity supplied by long
term gas contract has a negative relation with the quantity traded in short term gas
market. More investment in local technology also reduces the quantity trade in the
short term gas market. Moreover, the price of the short term gas market is affected by
the gas quantity of the long term contract and the investment in local technology in a
similar way with the quantity of short term gas market is.
When moving to the investment decision, we can find that the investment decision is
negatively affected by the quantity of the long term gas contract while the way that it
is affected by the per unit cost of gas and the elasticity remains the same with the
scenario one.
After rewriting the expressions of the short term gas price and quantity by putting the
expression of investment term into the expressions of short term gas price and
quantity, we get the results that the short term gas quantity is negatively affected by
the long term gas quantity while the short term gas price has nothing to do with long
term gas quantity. Whether the results holds up for all situations or just for the linear
gas demand and cost function, we do not really know. We will discuss it in the future.
Besides, the investment cost k has a positive effects on both the short term gas price
and quantity while the per unit cost of gas c has contrary effects on the short term gas
21
price and quantity.
4.3 the elasticity
Now we turn to the effect of different investment item
on the elasticity of price.
Rewriting the function (4.25), we get:
b
3( A QLT ) 2
8k c 2
(4.30)
From (4.30), we see that without investment item , the elasticity is bigger than it is with . It
shows that with the choice of investment in new technology, the price is less sensitive in long term.
The result explains why the long demand elasticity is lower than the short term demand in gas
market in the paper of Neuhoff and Hirschhausen (2005).
Above we see how investment in new technology and long term gas contract affects
the price and the demand in gas market, but it is not clear how much the investment in
local technology and long term gas contract affect others (c. price, total social welfare)
excluding other external factors (c. elasticity, cost) . To see the relation between
quantity of long term gas contract and other factors more clearly and straightforward,
we now turn to numerical examples.
5 Numerical Example
Figure 2
From Figure 2, we see that fixing A=100, b=0.9, c=10, k=100 both the welfare of the
importer and the welfare of exporter are increasing as the gas quantity bought under
22
long term gas contract becomes bigger. The total social welfare hence increases as
well. This shows that gas trading under long term gas contracts leads to more social
efficiency. Both exporter and importer benefit from long term gas contract. We
observe that after a certain point ( the investment in local technology becomes zero)
the profit of export decreases. The possible reason for this decrease is that a lower
price leads to a lower profit. There is enough gas supplied by the long term gas
contract so that there is no need for investing in local technology anymore. When
there is no investment in local technology, the price is affected by the demand in the
short term gas market. Less demand in the short term gas market as a big part of gas is
supplied by the long term gas contract leads to a lower price and hence the profit of
the exporter decreases. Eventually, the price reaches the lowest point which equals to
the marginal cost and the profit of the exporter is zero.
Figure 3
Figure 3 shows the movement of total demand, local supply and the supply of the
exporter as the gas bought through long term gas contracts increases. The local supply
decreases while the supply of exporter increases. In the end, all the demand is
supplied by the exporter. The demand remains the same until there is no investment in
local technology. The reason is when there is no investment in local technology the
price decreases until the price reaches its lowest point. This price decrease leads the
demand increase until the price is steady again.
23
Figure 4
Figure 4 shows the influence in investment in local technology and short term gas
price by the increase of long term gas quantity. The investment in local technology
decreases then becomes zero as the gas supplied by the long term gas contract
increases. The short term gas price remains the same until the investment in local
technology becomes zero. The decrease of price stops when the price reaches its
lowest point which equals to the cost of the gas.
Combining all the numerical results above, we can see that it’s better for the producer
to get all gas supply from long term gas contract instead of investing in local
technology.
6 Conclusion
As we all know, gas is an important natural resource used in many sectors.
Concerning that gas is a non-renewable and unevenly distributed resource, market
power plays an important role in gas market. As shown in this paper, compared the
investment decision in local technology which is as long as c 2
2k the social planner
will invest the local technology and the quantity the producer use will fully come
from the local technology in perfect competitive market, the producer will invest in
local technology as long as c 2
8k due to the seller market power. From the different
decision constraints, we can see the market power leads to inefficiency of the decision
on investment in local technology. By stating a three stage game model, we see that
the correlations among investment in local technology, short term gas price and
24
quantity and long term gas and quantity in the situation that there is market power in
gas market since we assume there is only one producer and one exporter. As is shown
in the model, investment in local technology has a negative relation with short term
gas price, which means with investment in local technology the producer gains
bargaining power so that the price becomes lower. Similarly, the investment in local
technology will reduce the quantity of gas trade in short term market. It is obvious
that if producer gets more supply by himself the demand in short term gas market
decreases. When moved to the optimal choice of investment in local technology, we
can see it is affected by the per unit gas cost, cost of building a new generation, the
quantity of long term gas contracts and the demand elasticity. By fixing the per unit
gas cost, the cost of building a new generation and the demand elasticity, we can see
how the quantity of long term gas contracts affect the investment in local technology
in numerical examples. Although after rewriting the expressions of short term gas
price and quantity by putting the expression of investment term into the expressions of
short term gas price and quantity, we get the results that the short term gas quantity is
negatively affected by long term gas quantity while the short term gas price has
nothing to do with long term gas quantity, we can not conclude that it is in general
situation since we have linear demand function and linear cost function assumption.
Finally, the numerical examples show that the producer can make optimal profit by
buying all gas he needs from long term gas contracts.
25
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