Unit-Contingent Power Purchase Agreement and Asymmetric Information about Plant Outage

41 Pages Posted: 19 Jan 2009 Last revised: 3 Apr 2012

See all articles by Owen Q. Wu

Owen Q. Wu

Indiana University - Kelley School of Business

Volodymyr Babich

McDonough School of Business, Georgetown University

Date Written: October 2011

Abstract

This paper analyzes a unit-contingent power purchase agreement between an electricity distributor and a power plant. Under such a contract the distributor pays the plant a fixed price if the plant is operational and nothing if plant outage occurs. Pricing a unit-contingent contract is complicated by the fact that the plant’s true status is its private information. The difference between the electricity spot price and the unit-contingent contract price provides an incentive for the plant to misreport its status and earn profit at the distributor’s expense. To prevent misreporting, the distributor may inspect the plant and levy penalties if misreporting is discovered. We find that some type of misreporting under certain circumstances can benefit both the plant and the distributor, because it serves as a risk-allocation mechanism between the two parties. We show that such a risk-allocation mechanism is equivalent to using state-contingent options and prohibiting misreporting.

Keywords: unit-contingent contract, asymmetric information, Bayesian equilibrium, risk allocation

Suggested Citation

Wu, Owen Q. and Babich, Volodymyr, Unit-Contingent Power Purchase Agreement and Asymmetric Information about Plant Outage (October 2011). Ross School of Business Paper No. 1120, Available at SSRN: https://ssrn.com/abstract=1326438 or http://dx.doi.org/10.2139/ssrn.1326438

Owen Q. Wu

Indiana University - Kelley School of Business ( email )

Business 670
1309 E. Tenth Street
Bloomington, IN 47401
United States

Volodymyr Babich (Contact Author)

McDonough School of Business, Georgetown University ( email )

3700 O Street, NW
Washington, DC 20057
United States

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