[PPT] - Measuring and Mitigating Market Power in Utility Industries David PowerPoint Presentation

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Measuring and Mitigating Market Power in Utility Industries

David Newbery, Cambridge University ACCC Regulation, Industry Structure and Market Power Conference, 31 July 2003

http://www.econ.cam.ac.uk/electricity

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ACCC '03 David Newbery 2

Dealing with market power in utilities

Competition Law: e.g. telecoms

– rule based approach favoured by EU – regulate: yes/no?

UK License approach: e.g. ESI

– pragmatic, flexible, MALC problematic

US Utility Law approach

– “just and reasonable” prices – powers to regulate can distort markets

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ACCC '03 David Newbery 3

Outline and examples

EU electricity markets
Mobile call termination

– designing regulation to mimic competition

Electricity wholesale markets

– the problems of measuring market power – The Market Abuse Licence Condition (MALC) – The dynamics of mitigating market power

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ACCC '03 David Newbery 4

Politically acceptable electricity liberalisation requires:

confidence in security of supply
sustainably competitive outcomes
absence of market abuse
ability to mitigate market power
credible regulation for efficient free entry

and investment These challenges remain in EU

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Preconditions for ESI liberalisation

rTPA + ownership unbundling: CEC a
adequate and secure supply: CEC a

– network adequate and reliable – production capacity adequate – security of supply of primary fuel

power to regulate competition: CEC r

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Competition policy for utilities

“competition where possible, regulate where not”

Leave markets to competition legislation?

– Ex post, penalties ⇒ legalistic, slow – dominance ~ 40+% of market – information collected only for case

⇒ need ex ante regulatory powers

UK licences as useful model

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Mitigating market power in US

Federal Power Act 1935 requires prices that

are ‘just and reasonable’

Selling at market-related prices requires:

– utility and affiliates do not have market power – competitive prices are just and reasonable – can withdraw right if there is market power – can re-impose cost-based prices caps

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ACCC '03 David Newbery 8

Contrast with Europe

no prior legislated cost-based regulation
no concept of ‘just and reasonable’ prices
little power to control wholesale prices
often limited power to get information

⇒ weak market surveillance – competitive tests derive from other markets

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0% 25% 50% 75% 100% 125% 150% A u s t r i a B e l g i u m F r a n c e G e r m a n y I t a l y N e t h e r l a n d s S w i t z e r l a n d S p a i n Gen 1 Gen 2 Gen 3 Fringe Imports

Source: Remaining capacity and availability factor from UCTE Power Balance Forecasts 2002-2004, NTC from ETSO (Winter 2001/2002), National Generation Shares from ICF consulting, Annual reports and presentations

Generation companies have MP within countries

... and retain market power due to transmission constraints

capacity demand

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Solutions?

Auction design for interconnectors

– legacy import auctions undesirable – efficient arbitrage mitigates importer power ⇒ single price better than pay-as-bid

Cross-border market integration

– can reduce market power in both markets

Increasing interconnection

– more companies can access market

Entry of IPPs based on gas

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Competition law based approaches: the case of mobile phones

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EC Communications Directives

markets effectively competitive where no
perator has Significant Market Power (SMP)
NRAs can only impose ex ante regulation if

– market review finds SMP that is likely to persist

regulation must be

– justified in relation to Directive’s objectives – appropriate, necessary, proportionate

Suggests regulation that mimics competition?

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Significant Market Power- SMP

defined to be equivalent to dominance:

Undertaking deemed to have SMP if, alone or jointly with others, it has “the power to behave to an appreciable extent independently of competitors, customers and ultimately consumers.” (Art. 14 , Directive 2002/21/EC) Mobile termination as an example

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Single dominance criteria

Market shares not conclusive but

< 25% presumptive of no SMP normally SMP requires > 40% > 50% presumptive of SMP

Allow for market shares that are: persistent,

emerging, fluctuating, rapidly growing

Barriers to and ease of entry

– control of infrastructure, econs of scale/scope, VI

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Regulating mobile termination

Oftel: Each MNO has SMP in the separate market for voice call termination on its network, and for 3 for wholesale 2G termination because:

– Calling Party Pays (and is insensitive to price) – Each MNO has 100% of relevant market – purchasers lack countervailing power – charges persistently and significantly above cost

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Whether to regulate termination

Initially unregulated: dynamic market
most MNOs not making profits
mark-up on termination subsidises handsets
contrast with receiving party pays (RPP)

– where termination subject to competitive pressure

CPP accelerates penetration compared to RPP

– cross-subsidy addresses network externality

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Mobile Subscribers as pecentage of access lines

10 20 30 40 50 60 70 1990 1991 1992 1993 1994 1995 1996 1997 1998 Jun- 99 p e rce n t UK CPP USA Mexico RPP

Mexico switches from RPP to CPP 1999

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Regulating termination charges

Oftel: price control for 2G voice termination

– EPMU on LRIC + network externality

no ex ante regulation of 3G termination

– emerging market, not yet profitable – 3G operators often use 2G termination – non-discrimination solves problem? – avoids issue of spectrum cost

Appealed to Competition Commission

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Setting the termination charge

To cover share of fixed and common costs

– must “promote efficiency and sustainable competition and maximise consumer benefits” (Art 13, AD, 2002/19/EC)

Access and call origination market

effectively competitive ⇒ Ramsey mark-up(+externality) on LRIC Not accepted by CC nor in Judicial Review

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Ramsey pricing

Constrained efficient solution

– subject to breakeven, recovers F&C costs – competitive markets will Ramsey price – Ramsey price termination ⇒ efficient outcome – termination less elastic ⇒ markup > EPMU

Oftel objections:

– Access/origination not competitive – difficult; elasticities hard to estimate – “unfair” to fixed line callers

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Making regulation more efficient

Leveraging regulation into non-SMP markets?
SMP in termination likely to remain

⇒ price control will need to be revisited

other price controls rely on contentious

theory/econometrics:

– WACC based on CAPM + econometrics – benchmarked X-factors based on econometrics

Ramsey pricing mimics competitive outcome

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Does the Competition Law approach work for ESI?

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Collective dominance if:

Market characteristics conducive to tacit

coordination, and

Tacit coordination sustainable:

– firms lack ability and incentive to deviate, given incentives for retaliation, and – Buyers, fringe firms, entrants cannot challenge tacit coordination

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Collective dominance criteria

Markets concentrated, transparent, mature
Low elasticity of demand
Homogenous product, similar costs, shares
Little excess capacity, barriers to entry
Excess pricing, profit

– little response to cost fall, barriers to switching

Electricity as a test case

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Collective dominance: electricity

1990 restructuring of England &Wales ESI

– unbundle G, T, D, S (supply) – create compulsory single-price gross Pool – flawed initial market structure – overgenerous price control on RECs

⇒ 12 years to structurally mitigate market power

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10 20 30 40 50 60 70 Apr-90 Apr-91 Apr-92 Apr-93 Apr-94 Apr-95 Apr-96 Apr-97 Apr-98 Apr-99 Apr-00 £/MWh (Jan 2000 prices)

PG gaming Ofgem price review Scheduling problems Nuclear outages reduce plant margin Price falls to meet price cap Annual price cap agreed for 2 years French strike & station failure Plant divestment to Eastern Low availability & Eastern bidding strategy NP & PG manipulation SMP manipulation Capacity withdrawal Further plant divestment

Pool prices since vesting

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Generation in England and Wales

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Source: John Bower (Oxford Institute for Energy Studies)

Capacity Ownership of Coal Generation 1990-2002

5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 A p r

9

O c t

9

A p r

9

1 O c t

9

1 A p r

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2 O c t

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2 A p r

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3 O c t

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3 A p r

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4 O c t

9

4 A p r

9

5 O c t

9

5 A p r

9

6 O c t

9

6 A p r

9

7 O c t

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7 A p r

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8 O c t

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8 A p r

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9 O c t

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9 A p r

O

c t

A

p r

1

O c t

1

MW

ALCAN Innogy National Power British Energy AES TXU/Eastern Edf International Pow AEP Edison EdF Powergen

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Collective dominance: the Pool

Markets concentrated, transparent, mature
Low elasticity of demand
homogenous product, similar costs, shares
little excess capacity, barriers to entry ?
excess pricing, profit

– little response to cost fall, – barriers to switching ??

But how to measure market power?

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ACCC '03 David Newbery 30

Theory of electricity pricing

Supply Function Equilibria

– Green and Newbery (1992) JPE

Cournot (by hour of day)

– facing a fringe of competitive gencos

Commercial software

– captures non-convexities

Agree on general form of equilibrium

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GW œ/MWh 5 10 15 20 25 30 35 40 45 20 40 60 80 100 Marginal Cost Maximum Demand 2-firm range 5-firm range

Feasible Supply Functions

Duopoly and Quintopoly

Calibrated for England 1990

A B C D X demand variation Cournot line

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Supply function equilibria

Spare capacity ⇒ Bertrand competition
Tight capacity ⇒ Cournot competition
Spot competition for uncontracted output
Entry determines average price
Peak price depends on capacity

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Wholesale prices depend on:

Number of competitive generators
Short-run elasticity of demand
Capacity relative to demand
Contract coverage
Entry conditions
Demand uncertainty

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Testing for collusion in a Pool

Is each company’s bid profit maximising

against all other firms’ bids?

C.f. A Sweeting MIT (2001) of GB Pool:

– 1990-94 bids too low for profit maximising – 1994-96 bid constrained by price cap – 1997-8 bids were profit maximising – 1999-2000 bids suggest tacit collusion - lower prices and higher outputs would increase profits

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Real Electricity PPP/UKPX and fuel cost 1990-2002

5 10 15 20 25 30 35

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 £/MWh 2001 prices

1000 2000 3000 4000 5000 6000 7000

Concentration HHI

electricity 12 m nth M A Electricity gas cost coal cost Coal HHI

Industry HHI

NETA

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Market Abuse Licence Condition

Similar to prohibition of abuse of dominance
defines SMP as “the ability to bring about,

independently of any changes in market demand or cost conditions, a substantial change in wholesale electricity prices”

– substantial = +5% for 30 days = £30 million = 0.4 % averaged over a year

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MALC - 2

CC AES and British Energy 2000:

– Ofgem does not define relevant market – does not require that price change is profitable – CC does not believe Co.s have incentive – CC argues that the appropriate response to rule manipulation is to change the rules – CC “mindful of the disadvantages of a broad, effects-based prohibition”

Case dismissed

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Evolution towards competition

Market power is legal, abuse is not

– concentrated markets constrained by this – less concentrated markets less constrained?

dominance “unlikely with less than 25% share”
difficulty of defining markets: cf MALC
very short term opportunity with non-storable output
Intermediate concentration problematic?
Highly competitive electricity insecure??

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Evolution to a competitive market

Mark-up

ver

comp. price Degree of competition Very concentrated,

paque or missing

markets 2-3 firms? Active markets competitive

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Bargaining for structural remedies

PG & NP’s bids for RECs referred to MMC

– denied by Sec. of State

dash for gas and more generators
impending supply liberalisation

– contracts shorter term, more competitive

reform of trading arrangements threatened

⇒ wholesale market becomes more risky NP+PG trade horizontal for vertical integration

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Supply and Generation in Great Britain, 2002

50 100 150 200 250 300 350

supply generation TWh Others Scottish Power London (EdF) AEP Scottish & Southern Energy AES PowerGen BNFL Centrica (British Gas) British Energy Innogy (Npower)

(2001/2 estimates, adjusted for the London/Seeboard, Innogy/Northern and PowerGen/TXU mergers) Source: R Green

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NETA Real electricity and fuel costs 1990-2002

5 10 15 20 25 30 35

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

£/MWh

Electricity coal cost gas cost NETA

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Difficulties with US approach

Re-regulation if prices not “just and reasonable”
How then to encourage investment?

– Peaking power may run a few hours/year – High prices needed to induce adequate reserves – threat of price caps leads to underinvestment

Standard Market Design to force suppliers to

contract ahead for capacity Regulation to offset regulatory failure

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Conclusions

Competition Law - where markets are either

competitive or need regulation

Licences have advantages for imperfectly

competitive markets

– require market surveillance – mechanism to ensure adequate information

Reducing the potential for tacit coordination

may require structural reforms

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Measuring and Mitigating Market Power in Utility Industries

David Newbery, Cambridge University ACCC Regulation, Industry Structure and Market Power Conference, 31 July 2003

http://www.econ.cam.ac.uk/electricity

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ACCC '03 David Newbery 47

Acronyms-1

CC: Competition Commission CEC: Commission of European Communities EPMU: equi-proportional mark-up ESI: Electricity supply industry IPP: Independent Power Producer LRIC: Long run incremental cost MALC: market abuse licence condition MNO: mobile network operator MMC: Monopolies and Mergers Commission, now CC

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Acronyms-2

NRA: National Regulatory Authority NP: National Power PG: PowerGen REC: Regional Electricity (Distribution) Company rTPA: regulated Third Party Access SMP: Significant Market Power WACC: weighted average cost of capital 2G, 2G: 2nd, 3rd generation mobile