market power in the electricity market
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MARKET POWER IN THEELECTRICITY MARKET
Professor Joshua GansUniversity of Melbourne
ACCC Talk
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CoRE Research May 2009
Questions
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CoRE Research May 2009
Questions
Defining and measuring market power
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CoRE Research May 2009
Questions
Defining and measuring market power
Evaluating vertical mergers
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CoRE Research May 2009
Market Power: Definition
Market power is the ability of a firm to raise the market priceof a good or service.
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CoRE Research May 2009
Market Power: Definition
Market power is the ability of a firm to raise the market priceof a good or service.
Tuesday, 9 June 2009
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CoRE Research May 2009
Market Power: Definition
Market power is the ability of a firm to raise the market priceof a good or service.
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CoRE Research May 2009
Market Power: Definition
Market power is the ability of a firm to raise the market priceof a good or service.
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CoRE Research May 2009
Market Power: Definition
Market power is the ability of a firm to raise the market priceof a good or service.
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CoRE Research May 2009
Market Power: Preconditions
Product differentiation (viz incumbents or entrants)
Limited rival capacity
Limited rival response (or numbers)
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CoRE Research May 2009
Market Power: Measurement
Key traditional indicator: price elasticity of firm demand, e
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CoRE Research May 2009
Market Power: Measurement
Key traditional indicator: price elasticity of firm demand, e
p c
c=
1
e
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Market Power: Measurement
Key traditional indicator: price elasticity of firm demand, e
Li =p c
c=
1
e=
si
E
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CoRE Research May 2009
Market Power: Measurement
Key traditional indicator: price elasticity of firm demand, e
Li =p c
c=
1
e=
si
E
siL
ii =
si
2
iE
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CoRE Research May 2009
Market Power: Measurement
Key traditional indicator: price elasticity of firm demand, e
Li =p c
c=
1
e=
si
E
siL
ii =
si
2
iE
HHI
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CoRE Research May 2009
Market Power: Measurement
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CoRE Research May 2009
Market Power: Measurement
p c
c=
1
e
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CoRE Research May 2009
Market Power: Measurement
Issues in electricity markets
p c
c=
1
e
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CoRE Research May 2009
Market Power: Measurement
Issues in electricity markets
Which price?p c
c=
1
e
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CoRE Research May 2009
Market Power: Measurement
Issues in electricity markets
Which price?
Capacity constraints
p c
c=
1
e
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CoRE Research May 2009
Market Power: Measurement
Issues in electricity markets
Which price?
Capacity constraints
Elasticity varies with demand
p c
c=
1
e
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CoRE Research May 2009
Simple Pool Model
Marginal Cost Generator A Generator B
at q = 1 2 3
at q = 2 3 6
at q = 3 7 8
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CoRE Research May 2009
Truthful Cost Revelation
Suppose demand is q = 3
Optimal dispatch: A = 2, B = 1
Marginal cost bidding: A =2, B = 1
Payments to each of $3 per unit
Achieves allocative and productive efficiency
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CoRE Research May 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 oneunit.
If B raises bid, then is not dispatched at all
Neither can do better -- an equilibrium!
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CoRE Research May 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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CoRE Research May 2009
Contracting
Forward contracts
Taken out to hedge price risk
Contracted capacity bid at marginal cost
Contract premium (contract price - spot price)
Related to risk aversion (expect to net out)
Value of reduction in spot market power
A liquid contract market makes the overall market morecompetitive
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CoRE Research May 2009
Added Value
Quantity
$
VoLL Industry
Supply
Demand
Gens Added
Value
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CoRE Research May 2009
Added Value
The added value of a generating company is the maximumamount of profits it can expect to earn from eithercontracting or the pool market.
Here a retailer may contract with the generator for VoLL priceon all of its capacity. This may prevent it paying a VoLL price toother generators.
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An Example
Two generators: A and B
VOLL = $100
A B
Capacity 20 10
Marginal Cost $2 $5
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CoRE Research May 2009
Added Value (Demand = 10)
Quantity
$
5
2
As AV = $30
Bs AV = $0
10 20
100
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Added Value (Demand = 15)
Quantity
$
5
2
As AV = $520
Bs AV = $0
10 20
100
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Added Value (Demand = 25)
Quantity
$
5
2
As AV = $1485
Bs AV = $475
10 20
100
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CoRE Research May 2009
Exit Option
Sometimes, a generator may not have sufficient value added
to keep operating.
Nonetheless, it may bring sufficient value to retailers even if itdoes not bring sufficient value to the market.
A generator has some value if it reduces the added value ofother generators.
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CoRE Research May 2009
Residual Supply Index
Percent capacity remaining after subtracting is capacity tosupply to prompt market
RSIi =Total Capacity less i's Relevant Capacity
Total Demand=
kjj i + xiD
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CoRE Research May 2009
Residual Supply Index
Percent capacity remaining after subtracting is capacity tosupply to prompt market
RSIi =Total Capacity less i's Relevant Capacity
Total Demand=
kjj i + xiD
Total regionalsupply + net
imports
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CoRE Research May 2009
Residual Supply Index
Percent capacity remaining after subtracting is capacity tosupply to prompt market
RSIi =Total Capacity less i's Relevant Capacity
Total Demand=
kjj i + xiD
Total regionalsupply + net
imports
is capacity lesscontract
obligations
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CoRE Research May 2009
Residual Supply Index
Percent capacity remaining after subtracting is capacity tosupply to prompt market
RSIi =Total Capacity less i's Relevant Capacity
Total Demand=
kjj i + xiD
Total regionalsupply + net
imports
is capacity lesscontract
obligations
Metered loadplus purchased
ancillary services
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CoRE Research May 2009
Residual Supply Index
RSI > 1: gen has less influence on price
RSI < 1: gens uncommitted capacity is needed to fill demand
Gen considered pivotal if RSI < 1.1
(Related to HHI adjusted for contract position)
Li
1 ri
E
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Measurement
Vertical concentration measure
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
VHHI=
1
Es
imax{s
i,
i}
i=1
N
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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 HHIs 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 higherconcentration
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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.
Bushnell, Mansur & Saravia: had vertical arrangements beenimpeded in California, prices would have been vastly higher.
Need to look at vertical integration when understandingimpact of horizontal market structure.
Vertical integration can limit the exercise of market power
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CoRE Research May 2009
Natural Hedge
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Natural Hedge
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Natural Hedge
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Inverted U?
0% 100%
WholesalePrices
Degree of Vertical Integration
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C R R h M 2009
Climate Change Impact
Policies will increase the marginal cost of emitting fuels
Designed to encourage entry (capacity) of non-emitting fuels
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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