Strategic Forward Trading and Technology

Abstract

Motivated by the electricity industry, we analyse the commoditisation of supply chains and show that operational factors, apart from their direct effects on production costs, can influence market prices indirectly through altering the balance of spot and forward trading. We study how heterogeneous suppliers optimally co-ordinate sales in spot and forward markets, and how buyers make procurement decisions. Forward trading allows risk sharing over spot uncertainty, but it also affects spot outcomes through the production commitments of strategic producers. We show how feedback between these hedging and strategic rationales for forward trading drives equilibrium prices and volumes. In the context of an example from the electricity industry, where there is typically a diverse mix of production processes, we analyse flexible (gas), inflexible (nuclear), and intermittent (wind) technologies and show, for example, how increasing the capacity of intermittent renewable electricity generation affects trading, production decisions, and the forward to spot price relationship. In particular, despite its lower marginal cost, more intermittent capacity may not necessarily reduce prices due to its impact on forward trading. We discuss the policy as well as the managerial implications.