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MARKET POWER IN THE ELECTRICITY MARKET

Professor Joshua Gans University of Melbourne ACCC Talk

Tuesday, 9 June 2009

Questions

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Tuesday, 9 June 2009

May 2009

Questions

• Defining

and measuring market power

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Tuesday, 9 June 2009

May 2009

Questions

• Defining

and measuring market power vertical mergers

• Evaluating

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Tuesday, 9 June 2009

May 2009

Questions

• Defining

and measuring market power vertical mergers

• Evaluating • Impact

of climate change policy

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Tuesday, 9 June 2009

May 2009

Market Power: Definition

“Market power is the ability of a firm to raise the market price of a good or service.”

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Tuesday, 9 June 2009

May 2009

Market Power: Definition

“Market power is the ability of a firm to raise the market price of a good or service.”

CoRE Research
Tuesday, 9 June 2009

May 2009

Market Power: Definition

“Market power is the ability of a firm to raise the market price of a good or service.”

CoRE Research
Tuesday, 9 June 2009

May 2009

Market Power: Definition

“Market power is the ability of a firm to raise the market price of a good or service.”

CoRE Research
Tuesday, 9 June 2009

May 2009

Market Power: Definition

“Market power is the ability of a firm to raise the market price of a good or service.”

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Tuesday, 9 June 2009

May 2009

Market Power: Preconditions

Product differentiation (viz incumbents or entrants) Limited rival capacity Limited rival response (or numbers)

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May 2009

Market Power: Measurement
Key traditional indicator: price elasticity of firm demand, e

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Tuesday, 9 June 2009

May 2009

Market Power: Measurement
Key traditional indicator: price elasticity of firm demand, e
p−c 1 = c e

CoRE Research
Tuesday, 9 June 2009

May 2009

Market Power: Measurement
Key traditional indicator: price elasticity of firm demand, e
p − c 1 si = = c e E

CoRE Research
Tuesday, 9 June 2009

May 2009

Market Power: Measurement
Key traditional indicator: price elasticity of firm demand, e
p − c 1 si Li = = = c e E

CoRE Research
Tuesday, 9 June 2009

May 2009

Market Power: Measurement
Key traditional indicator: price elasticity of firm demand, e
p − c 1 si Li = = = c e E

∑ sL
i i

i

∑s =
E

2 i i

CoRE Research
Tuesday, 9 June 2009

May 2009

Market Power: Measurement
Key traditional indicator: price elasticity of firm demand, e
p − c 1 si Li = = = c e E

∑ sL
i i

i

∑s =
E

2 i i

CoRE Research
Tuesday, 9 June 2009

May 2009

Market Power: Measurement
Key traditional indicator: price elasticity of firm demand, e
p − c 1 si Li = = = c e E

∑ sL
i i

i

∑s =
E

2 i i

HHI

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Tuesday, 9 June 2009

May 2009

Market Power: Measurement

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Tuesday, 9 June 2009

May 2009

Market Power: Measurement

p−c 1 = c e

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Tuesday, 9 June 2009

May 2009

Market Power: Measurement
Issues in electricity markets
p−c 1 = c e

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Tuesday, 9 June 2009

May 2009

Market Power: Measurement
Issues in electricity markets
p−c 1 = c e

Which price?

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Tuesday, 9 June 2009

May 2009

Market Power: Measurement
Issues in electricity markets
p−c 1 = c e

Which price? Capacity constraints

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Tuesday, 9 June 2009

May 2009

Market Power: Measurement
Issues in electricity markets
p−c 1 = c e

Which price? Capacity constraints Elasticity varies with demand

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May 2009

Simple Pool Model
Marginal Cost at q = 1 at q = 2 at q = 3
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Tuesday, 9 June 2009

Generator A 2 3 7

Generator B 3 6 8
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Truthful Cost Revelation
• Suppose • Optimal • Marginal

demand is q = 3 dispatch: A = 2, B = 1 cost bidding: A =2, B = 1 to each of $3 per unit allocative and productive efficiency
May 2009

• Payments • Achieves
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Tuesday, 9 June 2009

Equilibrium Behaviour
Suppose demand = 2 units • MC bidding: either A = 2 or (A = 1, B = 1)
• • • •

Price equals $3 A earns $1 and B earns $0

Can either do better? If A raises bid on second unit to 4, means only dispatched for one unit. • If B raises bid, then is not dispatched at all
• •

Neither can do better -- an equilibrium!
May 2009

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Tuesday, 9 June 2009

Market Power
Suppose (again) that demand = 3 units • MC Bidding: • A earned $1 and B earned $0 • Can either generator do better? • If A bids second unit at $4, then earns $2 extra. • MC bidding not an equilibrium • New equilibrium • A bids (2, 5.9); B bids (3, 6) • Resulting price equals $5.9

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Tuesday, 9 June 2009

May 2009

Contracting
• Forward

contracts • Taken out to hedge price risk • Contracted capacity bid at marginal cost premium (contract price - spot price) • Related to risk aversion (expect to net out) • Value of reduction in spot market power

• Contract

•A

liquid contract market makes the overall market more competitive
May 2009

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Tuesday, 9 June 2009

Graphically
$ VoLL Industry Supply

Demand Quantity
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Added Value
$ VoLL Industry Supply

Gen’s Added Value Demand Quantity
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Added Value
• The

added value of a generating company is the maximum amount of profits it can expect to earn from either contracting or the pool market. a retailer may contract with the generator for VoLL price on all of its capacity. This may prevent it paying a VoLL price to other generators.
May 2009

• Here

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Tuesday, 9 June 2009

An Example
• Two

generators: A and B = $100
A Capacity Marginal Cost 20 $2 B 10 $5
May 2009

• VOLL

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Tuesday, 9 June 2009

Added Value (Demand = 10)
$ 100 A’s AV = $30 B’s AV = $0

5 2 10
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20

Quantity
May 2009

Added Value (Demand = 15)
$ 100 A’s AV = $520 B’s AV = $0

5 2 10
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Tuesday, 9 June 2009

20

Quantity
May 2009

Added Value (Demand = 25)
$ 100 A’s AV = $1485 B’s AV = $475

5 2 10
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Tuesday, 9 June 2009

20

Quantity
May 2009

Exit Option
• Sometimes, a

generator may not have sufficient value added to keep operating. may bring sufficient value to retailers even if it does not bring sufficient value to the market. generator has some value if it reduces the added value of other generators.

• Nonetheless, it

•A

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Tuesday, 9 June 2009

May 2009

Entry Value (Demand = 15)
$ 100 A’s AV = $520 B’s EV = $950

5 2 10
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20

Quantity
May 2009

Residual Supply Index
• Percent

capacity remaining after subtracting i’s capacity to supply to prompt market

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Tuesday, 9 June 2009

May 2009

Residual Supply Index
• Percent

capacity remaining after subtracting i’s capacity to supply to prompt market
Total Capacity less i's Relevant Capacity RSI i = = Total Demand

j ≠i

k j + xi D

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Tuesday, 9 June 2009

May 2009

Residual Supply Index
• Percent

capacity remaining after subtracting i’s capacity to supply to prompt market
Total Capacity less i's Relevant Capacity RSI i = = Total Demand

j ≠i

k j + xi D

Total regional supply + net imports
CoRE Research
Tuesday, 9 June 2009

May 2009

Residual Supply Index
• Percent

capacity remaining after subtracting i’s capacity to supply to prompt market
Total Capacity less i's Relevant Capacity RSI i = = Total Demand

j ≠i

k j + xi D

Total regional supply + net imports
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Tuesday, 9 June 2009

i’s capacity less contract obligations
May 2009

Residual Supply Index
• Percent

capacity remaining after subtracting i’s capacity to supply to prompt market
Total Capacity less i's Relevant Capacity RSI i = = Total Demand

j ≠i

k j + xi D

Total regional supply + net imports
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Tuesday, 9 June 2009

i’s capacity less contract obligations

Metered load plus purchased ancillary services
May 2009

Residual Supply Index
• RSI • RSI

> 1: gen has less influence on price < 1: gen’s uncommitted capacity is needed to fill demand Gen considered pivotal if RSI < 1.1 (Related to HHI adjusted for contract position)
1 − ri Li ≈ E

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Tuesday, 9 June 2009

May 2009

Vertical Integration
• Standard • Favour

concerns

integrated downstream unit and raise costs or exclude non-integrated units effective if have upstream market power have an incentive if can reduce downstream competition
May 2009

• Only • Only

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Tuesday, 9 June 2009

Measurement
• Vertical

concentration measure

VHHI =

1 E

si max{si , σ i } i=1

N

Ranges between 0 (perfect competition) and 10,000 (downstream monopoly)
Collapses to HHI (Downstream) when all downstream firms are net buyers of inputs or non-integrated • If there is integration then VHHI > HHI

Upstream concentration not relevant
Non-integrated upstream mergers do not change VHHI • Only look upstream if merger involves a net supplier

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May 2009

Some Examples
Example 1: • 4 equal sized upstream firms and 10 equal sized downstream firms • Up HHI = 2500; Down HHI = 1000 = VHHI • Vertical merger leaves HHI’s unchanged (no concern) but raises VHHI to 1150 (potential concern) • Example 2: • 8 downstream firms with 10% each and a 9th with a 20% share • If vertical merger involves large firm then HHI does not change but VHHI goes from 1300 to 1400 (no concern) despite higher concentration

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Tuesday, 9 June 2009

May 2009

Caveats For Electricity
• Regulated • Lerner

retail prices

index not as relevant with capacity constraints and contract prices on the contract market

• Impact

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Tuesday, 9 June 2009

May 2009

Evidence
• Mansur, PJM: examines

two generators with low retail shares (due to regulation and restructuring). As they lost retail share, their incentives to raise wholesale prices went up. & Saravia: had vertical arrangements been impeded in California, prices would have been vastly higher. Need to look at vertical integration when understanding impact of horizontal market structure. integration can limit the exercise of market power
May 2009

• Bushnell, Mansur

• Vertical

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Tuesday, 9 June 2009

Natural Hedge

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Tuesday, 9 June 2009

May 2009

Natural Hedge
Retailer hedges with own unit

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Tuesday, 9 June 2009

May 2009

Natural Hedge
Retailer hedges with own unit Reduces external contracting by amount of natural hedge

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Tuesday, 9 June 2009

May 2009

Natural Hedge
Retailer hedges with own unit Reduces external contracting by amount of natural hedge Increased exercise of market power

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Tuesday, 9 June 2009

May 2009

Evidence
• Examination • Predicted

of Purchase of Loy Yang A

increase in wholesale prices from impact of natural hedge (up to 256MW) = 10-25% post analysis of actual price increases using natural gas prices = 15-30%

• Ex

• Controlled • Identified
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Tuesday, 9 June 2009

using congested Vic to NSW transmission = 205
May 2009

Inverted U?
Wholesale Prices

0%

100%

Degree of Vertical Integration
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Tuesday, 9 June 2009

May 2009

Climate Change Impact
• Policies

will increase the marginal cost of emitting fuels to encourage entry (capacity) of non-emitting fuels

• Designed • Much

of this is intermittent and low cost

• Therefore, increases

net load variability • Will favour investment in peaking plant rather than baseload
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Tuesday, 9 June 2009

May 2009