Divesting Power G. Federico 1 A. L. López 2 October 2009 IEFE Seminar 1 Charles River Associates and IESE Business School (SP-SP). 2 IESE Business School (SP-SP). G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 1 / 30
Motivation I: market power mitigation in electricity Wholesale electricity markets prone to the exercise of market power Low demand elasticity Cost heterogeneity with capacity constraints Uniform pricing National/local markets Strong incumbency positions Market power mitigation a key policy consideration Ex-ante regulation (including merger control) Ex-post antitrust Physical or virtual plant divestments are often the main market power mitigation measures available to competition authorities/regulators G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 2 / 30
Motivation II: examples of divestments/VPPs Merger control EDF/EnBW (VPP, 2000) Nuon/Reliant (VPP, 2003) EDP/GDP (VPP/lease, 2004) Gas Natural/Endesa (Divestment, 2005) EDF/British Energy (Divestment and VPP, 2008) Gas Natural/Union Fenosa (Divestment, 2009) Ex-ante regulation Great Britain: divestments used after liberalisation (mid-1990s) Italy: divestments used prior to liberalisation (late 1990s) Spain/Portugal: VPPs introduced to mitigate market power (2008 onwards) Remedy for abuse of dominance Enel (VPP, 2006) RWE (VPP, 2008) E.On (divestment, 2008) G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 3 / 30
Common intuitions - and outstanding questions Distinction often made between ability and incentives assets Ability assets have higher marginal cost: lower opportunity cost of withholding Incentive assets have low marginal cost: provide incentives for withholding ability assets Divestments of ability assets can reduce scope for withholding - but: Which ability assets should be divested? Does one need to also address incentives to withhold by divesting some incentive assets? Can virtual contracts replicate the optimal divestment of ability and/or incentives plants? G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 4 / 30
Related literature Mostly focuses on the impact of …xed-price forward contracts (equivalent to baseload VPP) Standard market-power mitigation (Allaz and Vila (1993); Newbery (1998)) More recent papers highlight some potential de…ciencies of contracts in electricity markets (Schultz (2007); Zhang and Zwart (2006); and Fabra and de Frutos (2008)) No modelling of VPP vs divestments that we are aware of, or of relative e¤ectiveness of di¤erent types of divestments Willems (2006) distinguishes between …nancial and physical VPPs but both are contracts Wolak and McRae (2009) discuss di¤erent types of divestments in qualitative terms, by reference to recent US merger (Exelon/PSEG) G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 5 / 30
Aim of this paper Investigate the market power mitigation policy that leads to the greatest bene…t to consumers (for a given size of intervention) Divestments vs VPP Di¤erent types of divestments Di¤erent types of VPPs Model impact of (de)concentration of price-setting capacity Allow for extensive cost asymmetries in generation portfolios (from baseload to mid-merit and price-setting plants) Simplify nature of market power to allow for rich set of divestment options G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 6 / 30
Main results A unique optimal divestment can be identi…ed in a model of a dominant …rm with a competitive fringe the divested capacity needs to include price-setting generation plants, which would otherwise be withheld by the dominant …rm for divestments of intermediate size, the optimal divestment does not include the cheapest generation assets withheld by the dominant …rm, and the cost range of the divested capacity spans the post-divestment price the optimal divestment is e¤ective because it makes the residual demand faced by the dominant …rm more elastic, and can be several-fold more e¤ective than a baseload divestment The e¤ectiveness of VPPs is maximised when all of the options which are sold are exercised in this case the VPP reduces prices as much as a divestment of baseload generation of the same size this implies that divestments are much more pro-competitive than VPPs (in a one-shot setting) G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 7 / 30
Model set-up Standard model of dominant …rm with a competitive fringe Increasing and linear marginal cost function (symmetric): c i = γ q i for i = d , f Demand is completely price-inelastic: q d + q f = µ Fringe bids all of its output at cost: p = c f = γ q f , where q f = µ � q d Implies following pre-divestment equilibrium: d = µ 3 ; and p � = 2 q � 3 γµ Prices are above the competitive level ( p � > p c = 1 2 γµ ). Withheld output equals µ 6 G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 8 / 30
De…nition of (physical) divestment Transfer of contiguous segment of the marginal cost function of the dominant …rm to the fringe (through a competitive auction) Size of divestment de…ned as δ Position of divestment identi…ed by highest (marginal) cost of the divested units, de…ned as c (implies lowest cost of the divested units is c = c � γδ ) Divestment shifts both the marginal cost and residual demand schedules of the dominant …rm: Cost-increasing e¤ect Demand-reducing e¤ect (coupled with a demand-slope e¤ect) G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 9 / 30
Description of divestment Price, costs Price, costs Pre-divestment Pre-divestment γµ γµ residual demand residual demand γ γ Slope = - Slope = - ( ( ) ) γ γ ( ( ) ) γ γ + + δ δ γ γ µ µ − − δ δ q q Slope = - Slope = - 2 2 d d γ γ q q d d c c Pre-divestment Pre-divestment marginal cost marginal cost − − γδ γδ c c Divested units Divested units µ µ − − δ δ q q ' ' Quantity Quantity q q ' ' Figure: G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 10 / 30
Divestment size thresholds Three cases can be identi…ed for the impact of a divestment on prices, depending on its size as a share of total demand ( δ µ ) δ 12 Small divestments : µ < 1 � p 6 � 0 . 02 5 h i δ 12 2 Intermediate divestments : µ 2 1 � p 6 , 1 � p 5 6 δ 2 Large divestments : µ > 1 � p 6 � 0 . 18 G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 11 / 30
Divestments of intermediate size For intermediate divestments, the post-divestment price function is the following (as a function of the position of the plant divestment): Segment Price Range of c � � p � � ∆ p µ + δ I (baseload) γδ � c < γ 3 � � � � µ + δ µ + 2 δ II γµ � c � c < γ γ 3 3 � � � � p p � � 2 ∆ p µ + 2 δ 2 6 III � c < γ � 1 ( µ � δ ) γ 3 3 � � p 3 2 6 ( µ � δ ) � c < γ ( 3 IV 8 ( γ ( µ � δ ) + c ) � 1 5 µ + δ ) γ 3 5 µ + δ ) � c < p � + 3 ∆ p γ ( 3 V c � γδ c � p � + 3 ∆ p p � VI where ∆ p � γδ 3 . G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 12 / 30
Post-divestment price function (intermediate divestment) p p ( ) ( ) * * p p c c p p − − ∆ ∆ * * p p p p − 2 − 2 ∆ ∆ * * p p p p I I II II III III IV IV V V VI VI c c * * * * p p p p 3 3 + 3 + 3 ∆ ∆ 2 2 6 6 * * + + ∆ ∆ + 2 + 2 ∆ ∆ γ 5 γ 5 µ µ + δ + δ γ γ − − µ µ − − δ δ p p 1 1 ( ( ) ) p p p p p p 2 2 2 2 3 3 G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 13 / 30
Characteristics of optimal divestment (intermediate size) The optimal divestment is given by setting: ! p 2 6 c = ˆ ¯ c � γ � 1 ( µ � δ ) � 0 . 63 γ ( µ � δ ) 3 The divested capacity is marginal, but not ‘too’ high-cost: h � � µ �� , p � � p c , γ c 2 ˆ max 3 + δ The divestment is price-setting in the post-divestment equilibrium: p ( ˆ c ) 2 [ ˆ c � γδ , ˆ c ) G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 14 / 30
Position of the optimal divestment For δ 1 µ = 20 Price, costs Price, costs Pre-divestment Pre-divestment γµ γµ residual demand residual demand Pre-divestment Pre-divestment marginal costs marginal costs * * p p c c − − γδ γδ c c c c p p Optimal divestment Optimal divestment δ δ of size of size µ µ µ µ µ µ δ δ Quantity Quantity 3 3 2 2 G. Federico, A. L. López (October 2009) Divesting Power IEFE Seminar 15 / 30
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