Integrating Contracting and Spot Procurement with Capacity Options

This paper develops a framework for integrating contract markets with spot markets using tradable options for capacity. Sellers and Buyers may either contract for delivery in advance (the \contracting" option) or they may sell and buy some or all of their output/input in a spot market. Contract pricing involves both a reservation fee per unit of capacity and an execution fee per unit of output if capacity is called. The key question addressed is the structure of the optimal portfolios of contracting and spot market transactions for these Sellers and Buyers, and the pricing thereof in market equilibrium. We show that when Sellers properly anticipate demands to their bids, then bidding a contract execution fee equal to variable cost dominates all other bidding strategies yielding the same contract output. The optimal capacity reservation fees are determined by Sellers to trade o the risk of underutilized capacity against unit capacity costs. Buyers' optimal portfolios are shown to follow a merit order (or greedy) shopping rule, under which contracts are signed following an index that is an increasing function of the Sellers' reservation cost and execution cost. Existence and structure of market equilibria are characterized for the associated competitive game between Sellers, under the assumption that they know Buyer demand functions.