Contract Duration and Relationship-Specific Investments: Empirical Evidence from Coal Markets

Topics: Coal, Coal mining, Contract Pages: 44 (13029 words) Published: August 26, 2013
Contract Duration and Relationship-Specific Investments: Empirical Evidence from Coal Markets – Joskow 1994 This paper seeks to test empirically the importance of relationship-specific investments in determining the duration of coal contracts negotiated between coal suppliers and electric utilities.

Once the investments are sunk in anticipation of performance, "holdup" or "opportunism" incentives are created ex post which, if mechanisms cannot be designed to mitigate the parties' ability to act on these incentives, could make a socially cost-minimizing transaction privately unattractive at the contract execution stage. A coal contract generally specifies in advance a method for determining the price that the buyer is obligated to pay for each delivery. My hypothesis is that the more important relationship-specific investments are, the longer will be the period of time (or number of discrete transactions) over which the parties will establish the terms of trade ex ante by contract. I therefore expect to observe that the variation in the agreed upon duration of contractual commitments is directly related to variations in the importance of relationship-specific investments. As Klein et al. discuss, the sunk investments create a stream of quasi rents that gives one party or the other (or both) some ex post bargaining power. Williamson (1983, p. 526) identifies four distinct types of transaction-specific investments, three of which appear to be relevant to different types of coal supply relationships. The three types of relevance to coal market transactions are: (a) Site Specificity. (b) Physical Asset Specificity (c) Dedicated Assets

Williamson (1983) states that common ownership is the predominant response to site specificity. My work with coal supply arrangements indicates that common ownership (vertical integration) is much more likely to merge for mine-mouth plants than other types of plants, but that contracts are also used to govern exchange for about half of the mine-mouth plants constructed since 1960.

I therefore expect that contracts for supplies for mine-mouth plants will be much longer than the average contract involving supplies to other types of plants, other things equal. The fact that a plant is locked in to a particular type of coal does not necessarily imply that the buyer is locked in to a specific supplier. Whether or not the plant design/coal characteristic lock in also leads to a lock in with the current supplier depends on other characteristics of the transaction. In particular, it is likely that the relationship between this type of asset-specificity and ex post hold up or opportunism problems is related to inter- and intraregional variations in coal quality, least cost supply technology, and transportation alternatives. These considerations imply the following: Coal suppliers are likely to be less able to exploit the lock-in effect associated with boilers designed to burn coal with specific characteristics in the East than in the West. Thus the protection of a long-term contract is likely to be more desirable from the buyers' perspective. Thus, I expect that the greater the annual quantity of coal contracted for the longer will be the specified duration of the contract.

The greater heterogeneity in coal supplies and the difficulties of obtaining suitable transportation for it in the West, suggest that dedicated asset problems are likely to be more severe in the west than the east. To summarize, if variations in the importance of relationship-specific investments do in fact lead to variations in the extent to which the parties precommit to the terms of future trade ex ante, I expect to find that the duration of contractual relationships specified at the contract execution stage will vary systematically with three primary observable characteristics of coal supply transactions. First, whether the plant taking the coal is a mine-mouth plant or not. I expect to observe longer-term contracts...

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"Testing for Structural Change By DMethods in Switching Simultaneous Equations Models," Proceedings of the American Statistical Association, Business and Economics Section, 1979, 461-66
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