Analysis of Imperfect Competition in Natural Gas Supply Contracts for Electric Power Generation: A Closed-loop Approach

Abstract

The supply of natural gas is generally based on contracts that are signed prior to the use of this fuel for power generation. Scarcity of natural gas in systems where a share of electricity demand is supplied with gas turbines does not necessarily imply demand rationing, because most gas turbines can still operate with diesel when natural gas is not available. However, scarcity conditions can lead to electricity price spikes, with welfare effects for consumers and generation firms. We develop a closed-loop equilibrium model to evaluate if generation firms have incentives to contract or import the socially-optimal volumes of natural gas to generate electricity. We consider a perfectly-competitive electricity market, where all firms act as price-takers in the short term, but assume that only a small number of firms own gas turbines and procure natural gas from, for instance, foreign suppliers in liquefied form. We illustrate an application of our model using a network reduction of the electric power system in Chile, considering two strategic firms that make annual decisions about natural gas imports in discrete quantities. We also assume that strategic firms compete in the electricity market with a set of competitive firms do not make strategic decisions about natural gas imports (i.e., a competitive fringe). Our results indicate that strategic firms could have incentives to sign natural gas contracts for volumes that are much lower than the socially-optimal ones, which leads to supernormal profits for these firms in the electricity market. Yet, this effect is rather sensitive to the price of natural gas. A high price of natural gas eliminates the incentives of generation firms to exercise market power through natural gas contracts.