The strategic use of forward contracts: Applications in power markets

This dissertation develops three theoretical models that analyze forward trading by firms with market power. The models are discussed in the context of recently restructured power markets, but the results can be applied more generally.; The first model considers the profitability of large firms in markets with limited economies of scale and free entry. When large firms apply their market power, small firms benefit from the high prices without incurring the costs of restricted output. When entry is considered, and profit opportunity is determined by the cost of entry, this asymmetry creates the “curse of market power;” the long-run profits of large firms are reduced because of their market power. I suggest ways that large power producers can cope with the curse of market power, including the sale of long-term forward contracts. Past research has shown that forward contracts can demonstrate commitment to aggressive behavior to a competing duopolist. I add explicitly modeled entry to this literature, and make the potential entrants the audience of the forward sale. The existence of a forward market decreases equilibrium entry, increases the profits of large firms, and enhances economic efficiency.; In the second model, a consumer representative, such as a state government or regulated distribution utility, bargains in the forward market on behalf of end-consumers who cannot organize together in the spot market. The ability to organize in forward markets allows consumers to encourage economic efficiency. When multiple producers are considered, I find that the ability to offer contracts also increases consumer surplus by decreasing the producers' profits. In some specifications of the model, consumers are able to capture the full gains from trade.; The third model of this dissertation considers the ability of a large producer to take advantage of anonymity by randomly alternating between forward sales and forward purchases. The large producer uses its market power to always obtain favorable settlement on its forward transactions. Since other participants in the market cannot anticipate the large producer's eventual spot market behavior they cannot effectively arbitrage between markets. I find that forward transaction anonymity leads to spot price destabilization and cost inefficiency.