Analyzing Strategic Interaction in Multi-Settlement Electricity Markets: A Closed-Loop Supply Function Equilibrium Model


Multi-settlement electricity markets typically permit firms to bid increasing supply functions (SFs) in each market, rather than only a fixed price or quantity. Klemperer and Meyer’s (1989) single-market supply function equilibrium (SFE) model extends to a computable SFE model of a multi-settlement market, that is, a single forward market and a spot market. Spot and forward market supply and demand functions arise endogenously under a closed-loop information structure with rational expectations. The closed-loop assumption implies that in choosing their spot market SFs, firms observe and respond optimally to the forward market outcome. Moreover, firms take the corresponding expected spot market equilibrium into account in constructing their forward market SFs. Subgame-perfect Nash equilibria of the model are characterized analytically via backward induction. Assuming affine functional forms for the spot market and an equilibrium selection mechanism in the forward market provides for numerical solutions that, using simple empirical benchmarks, select a single subgame- perfect Nash equilibrium.

Incentives for a supplier in the forward market decompose into three distinct effects: a direct effect attributable solely to the forward market, a settlement effect due to forward contract settlement at the expected spot market price, and a strategic effect arising due to the effect of a firm’s forward market activity on the anticipated response of the firm’s rival. Comparative statics analysis examines the effect of small parameter shocks on the forward market SFs. Shocks that increase the elasticities of equilibrium supply and demand functions tend to make firms more aggressive in the forward market, in that they bid higher quantities at most prices. Expected aggregate welfare for the multi-settlement SFE model is intermediate between that of the single-market SFE model and that of the perfectly competitive case.

Last updated on 07/21/2021