Financial contracts as coordination device

• DOI: http://doi.org/10.1111/jems.12340
• Published date: 01 April 2020
• Author: Chloé Le Coq,Sebastian Schwenen
• Date: 01 April 2020

© 2020 The Authors. Journal of Economics & Management Strategy published by Wiley Periodicals, Inc.

J Econ Manage Strat. 2020;29:241–259. wileyonlinelibrary.com/journal/jems

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241

Received: 11 February 2019

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Revised: 11 October 2019

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Accepted: 23 December 2019

DOI: 10.1111/jems.12340

ORIGINAL ARTICLE

Financial contracts as coordination device

Chloé Le Coq

1,2

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Sebastian Schwenen

3,4,5

1

University of Paris II Panthéon‐Assas

(CRED), Paris, France

2

Stockholm School of Economics (SITE),

Stockholm, Sweden

3

School of Management, Technical

University of Munich, Munich, Germany

4

German Institute for Economic Research

DIW Berlin, Berlin, Germany

5

Mannheim Institute for Sustainable

Energy Studies (MISES), Mannheim,

Germany

Correspondence

Sebastian Schwenen, School of

Management, Technical University of

Munich, Munich, Germany.

Email: sebastian.schwenen@tum.de

Funding information

Energiforsk research program EFORIS;

Marianne and Marcus Wallenberg

foundation

Abstract

We study the use of financial contracts as bid‐coordinating device in multi‐unit

uniform price auctions. Coordination is required whenever firms face a

volunteer's dilemma in pricing strategies: one firm (the “volunteer") is needed

to increase the market clearing price. Volunteering, however, is costly, as

inframarginal suppliers sell their entire capacity whereas the volunteer only

sells residual demand. We identify conditions under which signing financial

contracts solves this dilemma. We test our framework exploiting data on

contract positions by large producers in the New York power market. Using a

Monte Carlo simulation, we show that the contracting strategy is payoff

dominant and provide estimates of the benefits of such strategy.

KEYWORDS

auctions, coordination, electricity, forward markets, volunteer's dilemma

JEL CLASSIFICATION

D21; D44; L41; L94

1

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INTRODUCTION

A variety of goods and services are traded in multi‐unit auctions. Classic examples include auctions for government

bonds (Hortaçsu, Kastl, & Zhang, 2018), spectrum rights (Cramton & Ockenfels, 2017), electricity (Fabra, von der Fehr,

& Harbord, 2006), emission allowances (Lopomo, Marx, McAdams, & Murray, 2011), or gas pipeline capacity (Newbery,

2002). The majority of multi‐unit auctions clear at a uniform price, which facilitates market entry (Ausubel, Cramton,

Pycia, Rostek, & Weretka, 2014). Depending on the market architecture, bidders may also take financial positions on

forward markets before participating in the auction.

The theoretical literature on strategic forward trading shows that forward contracts affect spot market prices, either

by enhancing or softening spot market competition (e.g., Allaz & Vila, 1993; Mahenc & Salanié, 2004). An example that

seems to contradict the extant findings, however, was observed in the New York power market, which operates as a

multi‐unit uniform price auction. Whereas two major producers signed forward contracts in 2006, the market price

stayed equal to the regulatory price cap before and after the contract start date. Both the U.S. Federal Energy Regulatory

Commission (FERC) and the Department of Justice (DOJ) investigated whether the contractual agreements constituted

market manipulation. Their findings differed significantly. FERC (2008) argued against market manipulation and

concluded that the contracts were instruments to hedge price risk. DOJ (2010), following Cramton (2007), found that

the contracts helped firms to avoid competitive bidding strategies.

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This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction in any medium, provided

the original work is properly cited.

Drawing from this case, we present a new theoretical framework to examine how forward contracts allow firms to

coordinate on one of multiple equilibria in the spot market. Previous findings on the strategic use of forward contracts

illustrate how firms use contracts to gain additional market share, leading to lower spot prices (Allaz & Vila, 1993) or

how firms use contracts to increase spot prices (Mahenc & Salanié, 2004). We thus offer a new rationale for signing

forward contracts, which is to avoid miscoordination in pricing strategies. We also contribute with an empirical

investigation of this rationale. So far, the extent empirical literature on strategic forward contracts has shown price‐

reducing effects of forward contracts (e.g., Wolak, 2003) and strategic price premia on forward markets (Ito & Reguant,

2016). To our knowledge, empirical findings on price coordination through forward contracts have not been

documented so far. We apply and test our model using rarely observed data on firms' financial positions from the case

investigated by FERC and DOJ. Simulating market outcomes with and without contracts, we show that forward

positions rule out competing (off‐)equilibrium outcomes and allow firms to coordinate on their pricing strategies.

For our theoretical analysis, we model a standard multi‐unit uniform price auction. The literature on multi‐unit

auctions considers continuous bid functions (e.g., Hortacsu & Puller, 2008; Klemperer & Meyer, 1989; Wilson, 1979) and

discrete bids (e.g., Fabra et al., 2006; Kastl, 2006, 2012). Moreover, Kastl (2012) finds that as the number of steps increases,

equilibrium conditions for discrete and continuous supply functions converge. In line with previous auction literature

applied to electricity markets (e.g., Fabra et al., 2006; Reguant, 2014; Schwenen, 2015), we however focus on discrete bids as

they well resemble the market environment that we study. Specifically, we model two large firms and a competitive fringe.

Before auction clearing, the two large firms can sign forward contracts with a financial intermediary. If neither firm's

capacity is sufficient to satisfy full demand, all pricing equilibria are characterized by one pivotal firm that clears the

auction.This price‐setting firm can charge a supra‐competitive price due to its market power vis‐á‐vis residual demand. Yet,

the firm compromises on selling parts of its capacity, similarly to how a standard monopoly firm would. Due to the

institutional setup in the New York power market, we model a game of complete information.

1

As Le Coq, Orzen, and Schwenen (2017) point out, firms in such a game face a coordination problem akin to the

volunteer's dilemma (Diekmann, 1985; Goeree, Holt, & Smith, 2017): one firm (the “volunteer”)isneededtoincrease

the market clearing price.

2

Volunteering, however, is costly, as inframarginal suppliers sell their entire capacity whereas

the volunteer only supplies residual demand. Our model illustrates conditions under which signing financial contracts

solves this dilemma. More precisely, we show that signing opposite forward contracts increases both firms' profits when

firms face the volunteer's dilemma. The contracts work as follows. The volunteering firm holds a long position, while the

nonvolunteering firm holds a corresponding short position. By holding a long position, the volunteer obtains the high

clearing price not only forits spot sales, but also for its financially contracted quantity. The other (“free‐riding”)firm,while

losing money via the contract, benefits as it sells full capacity with certainty, knowing that its rival volunteers.

We test our theoretical predictions by analyzing pricing strategies and contract choices in the New York power

market. Focusing on this market offers several advantages. First, the fundamentals of this market, for example, on

marginal costs, are in line with the characteristics of our model. Furthermore, the market was highly concentrated

during our period of observation, which corresponds to our model with dominant and fringe firms. Moreover, our

setting allows for exploiting detailed data on demand curves and firm capacities. Finally, given that the contracts at

stake were publicly investigated, we can make use of detailed information on underlying contract positions.

For our empirical analysis, we conduct a Monte Carlo simulation of market outcomes with and without observed

contracts. We first show that, without contracts, the two largest firms would face a volunteer's dilemma: There exist two

types of equilibria, in each of which one firm volunteers. Second, in line with our predictions, we find that the contract

positions ruled out one of the two types of competing equilibria of the volunteering game. Third, we show that firms'

contracting strategies were weakly payoff dominant, even at constant clearing prices before and after the contract start

date. Our empirical investigation further illustrates that profits obtained via the forward market were just sufficient to

achieve commitment and to reward the price‐setting firm for its volunteering role.

Our paper is closely related to the literature on strategic interaction in forward and spot markets as pioneered by

Allaz and Vila (1993). Starting from an oligopoly equilibrium on the spot market, they prove a competition‐enhancing

effect of forward markets. However, whether contracting triggers aggressive pricing behavior depends crucially on

the institutional and structural market features, for example, on whether market participants interact repeatedly

1

Demand, firm capacities, and also bids submitted to the auction are published ex‐post and hence firms can infer and learn about their competitors' forward and spot sales. We also assume that

contract positions of the dominant firms are common knowledge. This is in line with our empirical case, where the financial intermediary publicly searched for counterparties for the contract and later

was accused of coordinating financial flows, having to pay 4.8 USD million in disgorgement (DOJ, 2012).

2

Alternatively, the volunteer's dilemma can be interpreted as an N‐person battle of the sexes.

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