Divesting Power G. Federico 1 A. L. Lpez 2 October 2009 IEFE - - PowerPoint PPT Presentation

Divesting Power

• G. Federico1
• A. L. López2

October 2009

IEFE Seminar

1Charles River Associates and IESE Business School (SP-SP). 2IESE 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

• nwards)

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

• ptions
• 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): ci = γqi for i = d, f Demand is completely price-inelastic: qd + qf = µ Fringe bids all of its output at cost: p = cf = γqf , where qf = µ qd Implies following pre-divestment equilibrium: q

d = µ

3 ; and p = 2 3γµ Prices are above the competitive level (p > pc = 1

2γµ).

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

Slope = - Slope = -

µ ' q

γ

2 γ d

q γ γµ

( )

δ µ γ −

c γδ − c

δ − ' q

Divested units Quantity Price, costs

( )

δ γ +

d

q

Pre-divestment residual demand Pre-divestment marginal cost Slope = - Slope = -

µ ' q

γ

2 γ d

q γ γµ

( )

δ µ γ −

c γδ − c

δ − ' q

Divested units Quantity Price, costs

( )

δ γ +

d

q

Pre-divestment residual demand Pre-divestment marginal cost

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)

Small divestments:

δ µ < 1 12 5 p 6 0.02

Intermediate divestments:

δ µ 2

h 1

12 5 p 6, 1 2 p 6

i Large divestments:

δ µ > 1 2 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 I (baseload) p ∆p γδ c < γ

• µ+δ

3

• II

γµ c γ

• µ+δ

3

• c < γ
• µ+2δ

3

• III

p 2∆p γ

• µ+2δ

3

• c < γ
• 2

p 6 3

1

• (µ δ)

IV

3 8(γ(µ δ) + c)

γ

• 2

p 6 3

1

• (µ δ) c < γ( 3

5µ + δ)

V c γδ γ( 3

5µ + δ) c < p + 3∆p

VI p c p + 3∆p 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

p ∆ − 2

*

) ( 1 3 6 2 δ µ γ −         −       +δ µ γ 5 3

p

p ∆ + 3

*

c

p

I II III IV V VI

( )

c p

p

p ∆ + 2

* p

p ∆ + 2 2

*

*

p

p

p ∆ −

* p

p ∆ − 2

*

) ( 1 3 6 2 δ µ γ −         −       +δ µ γ 5 3

p

p ∆ + 3

*

c

p

I II III IV V VI

( )

c p

p

p ∆ + 2

* p

p ∆ + 2 2

*

• 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: ¯ c = ˆ c γ 2 p 6 3 1 ! (µ δ) 0.63γ (µ δ) The divested capacity is marginal, but not ‘too’ high-cost: ˆ c 2 h max

• pc, γ

µ 3 + δ

• , p

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

µ = 1 20

µ γµ c γδ − c

Optimal divestment

• f size

Quantity Price, costs Pre-divestment residual demand

2 µ 3 µ

*

p

c

p

Pre-divestment marginal costs

δ

δ

µ γµ c γδ − c

Optimal divestment

• f size

Quantity Price, costs Pre-divestment residual demand

2 µ 3 µ

*

p

c

p

Pre-divestment marginal costs

δ

δ

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 15 / 30

E¤ectiveness of optimal divestment (intermediate size)

The optimal divestment is e¤ective because

it induces the …rm to price on the ‡atter segment of its residual demand, it is not cost-increasing for the dominant …rm, it is su¢ciently competitive to constrain the dominant …rm.

The ratio between the price reduction achieved by the optimal divestment and of a baseload divestment can be expressed as R

• δ

µ

• = pp(ˆ

c) ∆p

at the lower bound of the relevant range of δ

µ, R

• δ

µ

• 9.9,

at the upper bound of the range, R

• δ

µ

• 2.7 (and also p(ˆ

c) = pc)

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 16 / 30

De…nition of VPP

VPPs are call options that are imposed on the dominant producer for a certain fraction of its generation output The options are sold through a one-o¤ VPP auction The option holders obtain a right to acquire output from the dominant …rm at a strike (or exercise) price ps, and can re-sell this

• utput in the spot market to obtain the market price p

Each option is then exercised whenever p > ps We assume that the VPP scheme entails the sale of a group of in…nitesimally small call options each with a di¤erent strike price

The sum of the volumes associated with the aggregate set of options equals δ The strike prices associated with each option is de…ned by an increasing and continuous linear function that has slope γ

The VPP therefore mimics a physical plant divestment of size δ, with cost slope γ

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 17 / 30

Pro…t functions with VPP

If the option is always exercised (i.e. pVPP(c) c) then the dominant …rm maximises: πd = pqd γ 2 (qd)2 +

Z q0

q0δ γxdx pδ

If only part of the option is exercised (i.e. pVPP(c) < c ) then the dominant …rm maximises: πd = pqd γ 2 (qd)2 +

Z µqd

q0δ

γxdx p(µ qd

• q0 + δ

) which exploits the fact that p/γ = qf = µ qd.

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 18 / 30

Impact of VPP

The post-VPP price function pVPP(c) has 3 distinct segments, for δ µ

2 :

Segment Price Range of c IVPP p ∆p γδ c < p ∆p IIVPP

1 2

c

2 + γ

• µ δ

2

• p ∆p c < p + 3∆p

IIIVPP p c p + 3∆p pVPP(c) is weakly increasing in c. The VPP which achieves the largest price reduction is achieved by setting c < p ∆p (i.e. selecting a baseload VPP which is exercised in its entirety)

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 19 / 30

Impact of VPP

*

p

p

p ∆ −

*

c

p

( )

c p

p

p ∆ + 3

* p

p ∆ −

*

IIIVPP IIVPP IVPP

( )

c pVPP

450

*

p

p

p ∆ −

*

c

p

( )

c p

p

p ∆ + 3

* p

p ∆ −

*

IIIVPP IIVPP IVPP

( )

c pVPP

*

p

p

p ∆ −

*

c

p

( )

c p

p

p ∆ + 3

* p

p ∆ −

*

IIIVPP IIVPP IVPP

( )

c pVPP

450

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 20 / 30

Impact of VPP

Segment I: a baseload VPP (i.e. the options are all exercised) yields the same price reduction as a baseload divestment of the same size:

it removes an amount δ from the infra-marginal output of the dominant …rm, inducing it to price lower equivalent to losing some infra-marginal (i.e. low-cost) output through the divestment of baseload capacity to a competitive fringe, and facing a reduction in residual demand of the same size

Segment II: the highest strike price rises above p ∆p, implying that it is not pro…table to exercise some of the call options:

a higher amount of output for the dominant bene…ts from spot prices, inducing it to set higher level spot prices the price in this segment increases with the level of the highest strike price of the VPP, until none of the options are exercised in equilibrium

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 21 / 30

Divestments vs VPP

VPPs are never more e¤ective than divestments of the same size/position The comparison between the optimal and baseload divestment describes the relationship between the optimal divestment and the

• ptimal VPP as well

VPPs are less pro-competitive than divestments:

they a¤ect the …nancial ‡ows obtained by the dominant …rm but not the production capacity that is available to its competitors divestments can increase the output available to competitors without increasing the cost of the dominant …rm (i.e. if withheld capacity is divested) divestments can also induce the dominant …rm to price lower to ‘keep divested units out of the market’ (this incentive is absent with VPPs)

This comparison holds statically - it abstracts from the other possible (dis)advantages of VPPs

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 22 / 30

Welfare analysis (intermediate divestments)

A divestment changes total welfare through three e¤ects: ∆W (ˆ c) =

2 3 µ

Z

p(ˆ c) γ

γxdx | {z } cost saving competitive fringe

• p(ˆ

c) γ

Z

ˆ qδ

γxdx | {z } additional cost divested units

• µ+ˆ

qδ 4

Z

µ 3

γxdx | {z } . additional cost dominant …rm Welfare increases as long as the output of the dominant …rm (net of the divested output) does not decrease

This condition is satis…ed at the optimum divestment It is also satis…ed for other cost ranges, except for range III (in which case welfare can fall if the divestment is su¢ciently small)

A baseload VPP is also welfare-increasing since it leads to a net

• utput increase by the dominant …rm

However it increases welfare by less than the optimal divestment

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 23 / 30

Optimal small and large divestments

Small divestments ( δ

µ < 1 12 5 p 6 0.02)

it is optimal to divest plants which give incentives to the dominant …rm to set a price equal to the lowest cost of the divested capacity (corresponds to Segment V of the price function for intermediate divestments) cost of divested plants is between the pre-divestment price and the competitive price divested plants do not produce in equilibrium

Large divestments ( δ

µ > 1 2 p 6 0.18)

divesting the cheapest plants withheld by the dominant …rm pre-divestment (i.e. setting c = γ µ

3 + δ

• ) is optimal and achieves the

competitive price

• ptimal divestment is not unique (cheaper plants can also achieve the

competitive price) costs of divested capacity encompass post-divestment price (as in intermediate case)

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 24 / 30

Relative e¤ectiveness of the optimal divestment

Intermediate divestments Large divestments Small divestments

        µ δ R µ δ         µ δ R

( )

γµ c p

at optimal divestment

( )

γµ c p

• 1

2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

• 0.025 0.050 0.075 0.100 0.125 0.150 0.175 0.200 0.225 0.250 0.275 0.300 0.325 0.350 0.375 0.400 0.425 0.450 0.475 0.500

0.40 0.45 0.50 0.55 0.60 0.65 0.70 Intermediate divestments Large divestments Small divestments

        µ δ R µ δ         µ δ R

( )

γµ c p

at optimal divestment

( )

γµ c p

• 1

2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

• 0.025 0.050 0.075 0.100 0.125 0.150 0.175 0.200 0.225 0.250 0.275 0.300 0.325 0.350 0.375 0.400 0.425 0.450 0.475 0.500

0.40 0.45 0.50 0.55 0.60 0.65 0.70

Figure:

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 25 / 30

Extension with variable demand

Consider a case where demand is variable and a single divestment package needs to be selected

we constructed a numerical simulation based on demand and price data from the Italian spot market during 2007 based on the minimum and maximum demand observed during the period, we selected divestment sizes consistent with the intermediate case di¤erent demand duration levels considered for the impact of the divestment

Results of numerical illustration

For high demand variance (i.e. all demand levels considered), it is

• ptimal to select a divestment with a cost that is lower than that of

the optimal divestment at average demand. For low demand variance (i.e. only highest demand levels considered), it is optimal to select a divestment with a cost that is higher than that

• f the optimal divestment at average demand
• G. Federico, A. L. López (October 2009)

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Extension with variable demand

Price duration curves for λ = 100% and δ = 3GW

40 50 60 70 80 90 100 110 120 130 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Duration Price (Euro/MWh) Pre-divestment price Post-divestment price (optimal divestment) Post-divestment price (optimal divestment at average demand) Position of optimal divestment at average demand Position of optimal divestment

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 27 / 30

Extension with variable demand

Table: Simulation results with variable demand (λ = 100%), Euro/MWh.

δ = 2GW δ = 3GW δ = 4GW c p(c) c p(c) c p(c) Optimal 60.7 83.0 61.8 80.8 63.0 78.7 Optimal avg. demand 75.9 83.6 73.8 81.4 71.6 79 Baseload 29.2 85.5 30.3 84.4 31.4 83.3

Table: Simulation results with variable demand (δ = 3GW ), Euro/MWh.

λ = 100% λ = 50% λ = 20% c p(c) c p(c) c p(c) Optimal 61.8 80.8 88.3 89.5 100.9 95.1 Optimal at avg. demand 73.8 81.4 87.0 89.6 94.9 97.4 Baseload 30.3 84.4 46.8 95.7 52.9 103.6

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 28 / 30

Conclusions

We have identi…ed the most e¤ective divestment 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 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 with variable demand and high demand variance, optimal to divest cheaper capacity than the optimum at average demand (result reversed for low demand variance)

The e¤ectiveness of VPPs is maximised when all of the options 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 29 / 30

Conclusions

Policy implications: remedies

the choice of divested plants makes a signi…cant di¤erence to their e¤ectiveness as a remedy if a VPP is chosen as a market-power mitigation measure, best to set low strike prices rather than mimick the optimal divestment

Policy implications: merger control

acquisition of price-setting capacity by a …rm with market power can be signi…cantly more anti-competitive than baseload acquisition (i.e. it relaxes a more signi…cant competitive constraint)

• n the other hand, a well-chosen marginal divestment can o¤set the

e¤ects of a larger baseload acquisition

Results can be applied to antitrust cases in other industries with uniform pricing but increasing costs

• G. Federico, A. L. López (October 2009)

Divesting Power IEFE Seminar 30 / 30