ANÁLISIS MICROBIOLÓGICO

The purpose of this chapter is to model the relationship between vertical integration and market structure in electricity markets. We adopt the same hybrid approach of the last chapter to assess how changes in initial market parameters affect the generators’ decision to increase their participation in the electricity retail market. In other words, we analyze how changes in parameters such as σ1 (demand volatility), K (measure of spot market

power) and M = PK

i=1mi (initial degree of vertical integration) affect the

value of a retail expansion project (vertical integration) and the timing of this investment based on demand. In particular, this chapter analyzes the case of short-term projects to temporarily increase the vertical integration of a specific gentailer. 1

The determinants of vertical integration (VI) are a subject of intense debate. Section 3.3 offers a brief discussion about possible causes and consequences suggested by the literature. This chapter analyzes vertical integration from an investment perspective. In particular, we propose a

1_{The framework here developed can also be used to analyze long-term vertical inte-}

gration projects at the cost of modeling additional sources of uncertainty and allowing for retail price adjustments.

hybrid equilibrium/real options framework to model the vertical integra- tion decision.

The cost structure of the electricity retailers has several components. Retail businesses can be divided into two distinct groups: the low voltage regional distribution (lines business) and the commercialization of energy (energy business). On one hand, retailers operate and maintain copper and/or aluminium wires, power poles and connection points.2 _{On the}

other hand, retailers undertake community/social initiatives and market- ing campaigns in order to sell more electricity and strengthen their repu- tation. They also invest in call centres for account and fault management. For simplification, we assume in our equilibrium model (chapter 3) that the marginal costs associated with both the distribution O&M expendi- tures and selling expenses are negligible in comparison to the marginal costs of power generation.

Gentailers can raise their retail market share by either taking consumers from rival gentailers or from pure retailers. A gentailer’s decision to in- crease his vertical integration in the short-term (say, 4 years), involves un- dertaking projects for either expanding his regional distribution coverage or for increasing his marketing expenses. A considerable proportion of the costs associated with marketing campaigns and the expansion of lines coverage is irreversible. In particular, advertising in marketing campaigns entail totally sunk expenditure. It may also include a situation of a retailer entering a region as starting up, incurring transactions costs that are sunk. As discussed in the previous chapters, electricity markets are charac- terized by volatile spot prices and uncertainty about the demand. Both aspects directly affect the retail business. In an uncertain scenario with sunk costs, the value of flexibility is relevant to the decision of a generator to expand his participation in the retail market. In other words, the option to wait for undertaking the project of increasing his vertical integration

2_{In New Zealand, lines companies do this job and retailers contract for delivery service}

5.1. MOTIVATION 67 has a positive value.

Precisely, we consider the specific issue of a gentailer’s decision to ir- reversibly invest in a marketing campaign (and/or in an expansion of the distribution coverage) to increase his retail market share. For simplifica- tion, we assume that i) the effect of this campaign is instantaneous and has a pre-determined and certain duration, ii) the sunk costs associated with such campaign are one shot and instantaneous iii) demand is the only source of uncertainty, iv) the retail price is fixed for the investment horizon, v) competitors do not react strategically to this campaign and vi) forward contracts are given.

The reason for the assumptions i) and ii) is to focus on the determinants of vertical integration, avoiding complications arisen from more practical considerations about the nature of either the investments or the marketing campaign. The assumption iii) of only one state variable (demand) allows for the derivation of a closed-form solution for the problem. The rigidity of retail prices given by iv) is a reasonable approximation for the short and medium-term in markets that do not face abnormal changes in demand.3 The assumption v) of no predictable strategic reaction to an increase in a gentailer’s vertical integration simplifies the model considerably and en- ables for a ceteris paribus analysis.4 _{Since the retail price is assumed to be}

rigid, changes in demand that increase the spot prices have an initial neg-

3_{The timing and velocity of the retail price adjustments depend on the nature of the}

market and the retailers’ expectation about future demand. For example, the more elastic is the demand, the greater is the sensitivity of retail prices to changes in the expected demand. The length of contracts also affects how fast changes in expected demand are translated into variations of equilibrium retail prices. Last, retail prices are also frequently subject of price regulation (price cap or rate of return). The more binding are these price constraints, the less retail prices are enabled to vary. A preliminary work allowing for retail prices to react to demand periodically is currently being conducted and achieves similar qualitative results.

4_{The results of this chapter must be viewed as a best case scenario, since the rivals’}

reaction to the gentailer’s project of increasing his retail market share would almost cer- tainly decrease the value of his project. The extension of the framework here developed to enable for the possibility of strategic interactions among firms in the market is a promis- ing avenue for future research.

ative impact on the retail profit margin. Lastly, the assumption vi) implies that we take a partial equilibrium approach since forward contracts do not react to increases in vertical integration. That is, this exercise analyzes the value of vertical integration taking a specific K-dimensional vector of generators’ quantity contracted ~QC as given.5