Vertical integration may arise as a response to problems caused by contractual incompleteness (Grossman and Hart (1986), Bolton and Whinston (1993) and Rey and Tirole (2004). and as ways to acquire valuable private information about the production process (Arrow (1975)), to avoid rationing (Green (1986), Bolton and Whinston (1993)) and to weaken rivals (Bolton and Whinston (1993), Rey and Tirole (2004), Chemla (2003)). Uncertainty in demand, lack of market flexibility and (implied) risk aversion may also entail vertical integration (Hendrikse and Peters (1989), Carlton (1979), Perry (1989), Emons (1996)).
Specifically, vertical integration may prove efficient when the market fails to provide a full set of hedging instruments (Chao, Oren and Wilson (2005a,b)). But a number or questions remain not fully understood. To what extent and in which environments is vertical integration important? When does it take place? How can we quantify the respective effects of hedging instruments such as a forward market and the long-term risk management nature of vertical integration? The main objective of this paper is to clarify and to quantify the respective roles of forward markets and vertical integration in risk diversification and to discuss the relationship between vertical integration and forward hedging contracts.
pecifically, we aim at understanding the fundamental mechanisms of risk diversification in retail, forward and spot markets, together with the relationship linking each market’s equilibrium price. In order to focus on risk, we examine perfectly competitive markets in which agents disregard any influence they could have on prices or on the other agents’ decisions. We develop a two-date equilibrium model of perfectly competitive retail, forward and spot markets for a non-storable good. The non-storability of the good prevents the firm from benefiting from yet another possibility of ”home-made risk management”, which in our model is a central feature of vertical integration.
At time t = 0, downstream firms (or downstream subsidiaries of integrated firms) choose their retail market shares and forward positions for time t = 1. At that time, upstream firms (or downstream subsidiaries) produce the good, sell it to downstream entities on the spot market, in which consumers can buy. Decisions at time t = 0 must be taken under uncertain demand and spot price. Demand uncertainty is revealed at time t = 1 before production occurs. Agents have preferences defined by a mean-variance utility function, which can be thought of as a reduced form of traditional motives for risk management policy.
We derive the equilibrium prices and the quantities exchanged on the three markets in closed forms. We show that vertical integration and forward hedging are two ways of achieving risk diversification that exhibit similar properties. First, they both decrease the retail price. Second, they both enable agents with low generation capacity to corner larger market shares. Third, they both tend to decrease downstream firms’ utility when upstream firms are only partially integrated. Fourth, the impact of one of these levers on the retail price and on utilities is drastically reduced by the other.
Download
Forward Hedging and Vertical Integration: Theory and Evidence from the French Electricity Market
