Representing the Valuation of Take-or-Pay Provisions in Gas Markets With Limited Liquidity

Long-term contracting is the traditional governance mechanism to deal with the transaction costs associated with the specificity of gas industry assets. Long-term contracts have been often used to allocate risks among players, and to that end, they often include take-or-pay provisions. These clauses specify that buyers take the volume risk, as they are obliged to pay for a minimum amount of gas consumption. In exchange, buyers pay a predefined price, supposedly lower than the risk-neutral expectation of short-term gas prices. In that view, if the buyer is able to resell that gas in the short term, the contract is an effective hedge against short-term volatility. Otherwise, the contract does not act as a hedge but it becomes a sunk cost. The corresponding power producers' behavior involves not only output decisions but also financial decisions. To analyze that situation, this paper develops a new quantitative methodology that allows comparing risk-neutral valuations of gas and power markets decisions. We test the model in a real-size system, and show the additional cost of the power system associated with a possible illiquidity of the short-term gas market.