Market Power in The Electricity Market

MARKET POWER IN THE
ELECTRICITY MARKET
Professor Joshua Gans

University of Melbourne
ACCC Talk
Tuesday, 9 June 2009

Questions
CoRE Research May 2009

Questions
• Defining and measuring market power

Questions
• Evaluating vertical mergers

Questions
• Evaluating vertical mergers
• Impact of climate change policy

Market Power: Definition
“Market power is the ability of a firm to raise the market price

of a good or service.”









Market Power: Preconditions
Product differentiation (viz incumbents or entrants)
Limited rival capacity
Limited rival response (or numbers)

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

p−c 1
=
c e

p − c 1 si
= =
c e E

p − c 1 si
Li = = =
c e E

p − c 1 si
Li = = =
c e E
∑ s2
∑ sL
i i i = i i

p − c 1 si
Li = = =
c e E
∑ s2
∑ sL
i i i = i i

p − c 1 si
Li = = =
c e E
∑ s2
∑ sL
i i i = i i
E
HHI


p−c 1
=
c e

Issues in electricity markets

p−c 1
=
c e


p−c 1 Which price?
=
c e


=
c e
Capacity constraints


=
c e
Capacity constraints
Elasticity varies with demand

Simple Pool Model
Marginal Cost Generator A Generator B
at q = 1 2 3
at q = 2 3 6
at q = 3 7 8

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

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!
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

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 more

competitive
Graphically
$
VoLL Industry
Supply
Demand
Quantity
Added Value
$
VoLL Industry
Supply
Gen’s Added
Value
Demand
Quantity

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.
• Here 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.

An Example
• Two generators: A and B
• VOLL = $100
A B
Capacity 20 10
Marginal Cost $2 $5

Added Value (Demand = 10)
$
100 A’s AV = $30
B’s AV = $0
10 20
Quantity
$
100 A’s AV = $520
B’s AV = $0
10 20
Quantity
A’s AV = $1485
$
100 B’s AV = $475
2
10 20
Quantity
Exit Option
• Sometimes, a generator may not have sufficient value added

to keep operating.
• Nonetheless, it may bring sufficient value to retailers even if it

does not bring sufficient value to the market.
•A generator has some value if it reduces the added value of

other generators.

Entry Value (Demand = 15)
$
100 A’s AV = $520
B’s EV = $950
10 20
Quantity
Residual Supply Index
• Percent capacity remaining after subtracting i’s capacity to
supply to prompt market

Total Capacity less i's Relevant Capacity ∑ j ≠i

k j + xi
RSI i = =
Total Demand D


k j + xi
RSI i = =
Total Demand D
Total regional
supply + net
imports


k j + xi
RSI i = =
Total Demand D
Total regional i’s capacity less

supply + net contract
imports obligations


k j + xi
RSI i = =
Total Demand D
Total regional i’s capacity less Metered load

supply + net contract plus purchased
imports obligations ancillary services

• RSI > 1: gen has less influence on price
• RSI < 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

Vertical Integration
• Standard concerns
• Favour integrated downstream unit and raise costs or exclude

non-integrated units
• Only effective if have upstream market power
• Only have an incentive if can reduce downstream competition

Measurement
• Vertical concentration measure
∑
N
VHHI = 1
E
s
i=1 i
max{si
, σ i
}
• 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

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
Caveats For Electricity
• Regulated retail prices
• Lerner index not as relevant with capacity constraints and

contract prices
• Impact on the contract market

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 been

impeded in California, prices would have been vastly higher.
Need to look at vertical integration when understanding
impact of horizontal market structure.
• Vertical integration can limit the exercise of market power

Natural Hedge

Natural Hedge
Retailer
hedges with
own unit

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

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

Evidence
• Examination of Purchase of Loy Yang A
• Predicted increase in wholesale prices from impact of natural

hedge (up to 256MW) = 10-25%
• Ex post analysis of actual price increases
• Controlled using natural gas prices = 15-30%

• Identified using congested Vic to NSW transmission = 205

Inverted U?
Wholesale
Prices
0% 100%
Degree of Vertical Integration

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, increasesnet load variability
• Will favour investment in peaking plant rather than baseload


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MARKET POWER IN THE

Professor Joshua Gans

Tuesday, 9 June 2009

CoRE Research May 2009

• Defining and measuring market power

CoRE Research May 2009

• Defining and measuring market power

• Evaluating vertical mergers

CoRE Research May 2009

• Defining and measuring market power

• Evaluating vertical mergers

• Impact of climate change policy

CoRE Research May 2009

“Market power is the ability of a firm to raise the market price

CoRE Research May 2009

“Market power is the ability of a firm to raise the market price

CoRE Research May 2009

“Market power is the ability of a firm to raise the market price

CoRE Research May 2009

“Market power is the ability of a firm to raise the market price

CoRE Research May 2009

“Market power is the ability of a firm to raise the market price

CoRE Research May 2009

Product differentiation (viz incumbents or entrants)

Limited rival capacity

Limited rival response (or numbers)

CoRE Research May 2009

CoRE Research May 2009

CoRE Research May 2009

CoRE Research May 2009

CoRE Research May 2009

CoRE Research May 2009

CoRE Research May 2009

CoRE Research May 2009

CoRE Research May 2009

CoRE Research May 2009

Issues in electricity markets

CoRE Research May 2009

Issues in electricity markets

CoRE Research May 2009

Issues in electricity markets

CoRE Research May 2009

Issues in electricity markets

Elasticity varies with demand

CoRE Research May 2009

Marginal Cost Generator A Generator B

CoRE Research May 2009

• Marginal cost bidding: A =2, B = 1

• Payments to each of $3 per unit

• Achieves allocative and productive efficiency

CoRE Research May 2009

CoRE Research May 2009

• Contract premium (contract price - spot price)

•A liquid contract market makes the overall market more

CoRE Research May 2009

• The added value of a generating company is the maximum

CoRE Research May 2009

CoRE Research May 2009

• Sometimes, a generator may not have sufficient value added

• Nonetheless, it may bring sufficient value to retailers even if it

•A generator has some value if it reduces the added value of

CoRE Research May 2009

CoRE Research May 2009