A Supply Function Equilibrium Model with Forward Contracts - An Application to Wholesale Electricity Markets

Abstract

Research into modeling electricity markets is continuing and the subject of many debates. All types of competition (Cournot, Bertrand, supply function) are utilized and have their advantages and disadvantages for electricity markets. It is well-recognized that models cannot address all questions of interest; however they appear as an interesting tool for gleaning insights into the complexity of electricity markets and whether electricity markets may deliver the expected benefits of liberalization. In particular, proving the existence of market power is a very complex task. Market simulation models should not be seen as the ultimate solution but as one powerful tool. While it is extremely difficult to prove if any market participants were manipulating markets, simulation models can show (under certain assumptions) if it would have been profitable to do so. Such models can be used in addition to traditional competition analysis. For instance, a model can estimate different benchmarks (competitive, supply function) against which actual market prices may be compared. This paper provides a practical application of the SFE concept and how such theoretical approach can be used in practice. The model combines the supply function equilibrium approach in an expanded version of the Baldick et al. model (2000) with forward contracting based on the model of Newbery (1998). We also discuss the different options for market modeling with respect to strategic variables and forward contracting. Finally, we present an application of this model to the Dutch electricity market.