Comparison of long term contracts and vertical integration

Abstract : A common view is that electricity sectors should be unbundled and opened to competition, and that in such decentralised 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. However, increasing levels of generation ownership by electricity retailers or large electricity customers (and vice versa) – i.e. of vertical (re-)integration – have been observed in several liberalised systems. In this paper, we examine problems arising in contract markets in electricity systems. The resulting shortcomings in electricity contract markets suggest they are at best a partial and unsustainable solution to market power, retail competition, investment and supply security issues. We argue that high levels of vertical integration should not be a cause for concern, but rather may represent a more “natural” structure for the electricity sector. Vertical integration is argued to be a more self-sustaining institutional arrangement, and one which better addresses issues of wholesale market power, investment, and supply security. Its endogenous rise – even in electricity systems with relatively liquid contract markets – further suggests it has a natural role to play in decentralised electricity systems. Arguments are presented that vertical integration may in fact become a necessary form of industry organisation once a threshold level of integration has been reached.