Vertical Arrangements and Competition: Evidence from Electricity - - PDF document

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Vertical Arrangements and Competition: Evidence from Electricity Markets

Jim Bushnell, UC Energy Institute www.ucei.berkeley.edu

Presentation based upon “Vertical Arrangements, Market Structure and Competition: An Analysis of US Restructured Electricity Markets” with Erin Mansur and Celeste Saravia

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Outline

• Motivation

– How do different market attributes interact in determining market competitiveness?

• Punchline

– By traditional measures of horizontal market structure, California should have been the most competitive, not the least – vertical relationships played a key role in the “successful” markets

• General implications
• The details of the empirical study
• conclusions

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Monthly Average Wholesale Electricity Prices

20 40 60 80 100 120 140 160 180 200 Apr-98 Jul-98 Sep-98 Dec-98 Mar-99 May-99 Aug-99 Oct-99 Jan-00 Apr-00 Jun-00 Sep-00 Nov-00 Month ($/MWh) PJM New England California

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The Challenge of Competitive Electricity Markets

• Lack of price-responsive demand
• Costly storage
• Frequently binding capacity constraints, long

construction lead-times

– Transmission – Generation

• Even firms with small market shares can enjoy

substantial market power under the right (wrong) circumstances

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New England Energy Clearing Price and MC

20 40 60 80 100 120 140 160 180 Feb-99 May-99 Aug-99 Dec-99 Mar-00 Jun-00 Oct-00 Jan-01 Apr-01 Jul-01 Month ($/MWh) Energy Clearing Price Competitive Price 6

Average California PX price and MC

0.00 20.00 40.00 60.00 80.00 100.00 120.00 140.00 160.00 180.00 Apr-98 Jul-98 Nov-98 Feb-99 May-99 Aug-99 Dec-99 Mar-00 Jun-00 Oct-00 Jan-01 Month ($/MWh) PX price Competitive Price

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Kernel Regressions of Lerner Index vs. Capacity Ration (May - December 1999)

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Residual Demand/ Capacity (p-MC)/p New England California PJM

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Kernel Regressions of Lerner Index vs. Capacity Ration (May - October 2000)

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Residual Demand/ Capacity (p-MC)/p New England California PJM

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Market Comparisons

• Markets have experienced very different levels of

prices

– Counter-factual competitive prices can tell us the degree price exceeds these levels:

• Borenstein, Bushnell, and Wolak and Joskow and Kahn on

California

• Bushnell and Saravia on New England
• Mansur on PJM
• But why have they performed differently?

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Forward Commitments and Oligopoly

• Forward contracts increase spot production

– Less incentive to raise spot prices if most sales are already locked up under fixed-price contracts

• Desire to capture market from competition leads

to equilibrium forward contracting by all firms

– more output by all firms relative to when there is no forward market

• Pushing market forward allows for more supply

and demand response

– More potential suppliers

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Vertical structure and forward commitments

• Usually we think of wholesale (upstream) price determining the

(downstream) retail price

– Issues are usually foreclosure, raising rivals costs vs. double marginalization

• In some markets, retailers make forward commitments to customers

– utilities – telecom services – construction

• In these markets a vertical arrangement plays the same role as a

forward contract

– a pro-competitive effect – A balanced generator-retailer does not have a big net position in the wholesale market

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Retail and Generation in Great Britain, 2006

Innogy (Npower) Innogy (Npower) British Energy British Energy Centrica (British Gas) BNFL PowerGen AES Scottish & Southern Energy London (EdF) London (EdF) Scottish Power Scottish Power Others Others Centrica (British Gas) PowerGen Scottish & Southern Energy 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Retail Generation

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Retail and Generation in New Zealand, 2004

Meridian Meridian Contact Contact Genesis Genesis Mighty River Mighty River Trustpower Trustpower Other Other 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Retail Generation

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Retail and Generation in Spain, 2004

Endesa Endesa Iberdrola Iberdrola Union Fenosa Union Fenosa Hidrocantabrico Hidrocantabrico Other Other 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Retail Generation

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Retail and Generation in PJM, 1999

GPU Inc. GPU Inc. Public Service Electric & Gas Public Service Electric & Gas PECO Energy PECO Energy PP&L Inc. PP&L Inc. Potomac Electric Power Potomac Electric Power Baltimore Gas & Electric Baltimore Gas & Electric Other Other 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Retail Generation

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Retail and Generation in New England 1999

Northeast Util. Northeast Util. PG&E N.E.G. PG&E N.E.G. Mirant Sithe FP&L Energy Wisvest Other Other 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Retail Generation

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Retail and Generation in California 1999

PG&E PG&E SCE SCE AES/Williams Reliant Mirant Duke Dynegy/NRG Other Other 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Retail Generation

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Market Comparisons

• Role of Vertical Arrangements

– Almost no policy discussion of impact of retail policies on vertical arrangements like long term contracts and vertical integration.

• California required divestiture and prohibited long term

contracts (foreclosure concerns)

• New England required “vesting” contracts
• PJM firms remained vertically integrated in generation,

transmission, and distribution

– We ask: what is the relative influence of market rules, horizontal structure, and vertical arrangements on market performance

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Approach

• abstract away from specific market rules

and establish bounds on the potential scope of impact of those rules

• Bounds are established by horizontal

structure and vertical arrangements

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Supply Function Equilibrium

Green and Newbery (1992)

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$ Q Dmax Dmin Cournot competitive

Green and Newbery (1992)

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$ Dmax Dmin Bound on NC Equilibrium

• utcomes

Cournot competitive

Bounds on Non-Cooperative Outcomes

Qsupplied

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$ Qsupplied Dmax Dmin Bound on NC Equilibrium

• utcomes

Cournot competitive

Retail Obligations/Contracts Reduce Bounds

Contract Q

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Methodology

• Data on spot price, quantity demanded, vertical

commitments, and unit-specific marginal costs.

• Estimate supply of fringe firms.

– Calculate residual demand.

• Simulate market outcomes under:

– 1. Price taking behavior: P = C’ – 2. Cournot behavior: P + P’ * q = C’ – 3. Cournot behavior with vertical arraignments: P + P’ * (q-qc) = C’

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Residual Demand function

⎟ ⎠ ⎞ ⎜ ⎝ ⎛ − = + = β α β α

t t t actual t actual t t

Q p p Q exp ) ln(

• Source of “residual demand” price elasticity in model
• We observe import quantities, market price, and weather conditions

in neighboring states

• The demand curve is fit through the observed price and quantity
• utcomes.
• Estimates of price responsiveness are greatest in California (β≈5400)

relative to New England (β≈1180) and PJM (β≈860).

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28 29 30

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Price comparison on peak

1000 246 Same Cournot (“n.v.a.”) 87 53 45 Cournot 35 39 35 Competitive 97 55 43 Actual PJM New England California Price

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Price comparison off peak

901 98 Same Cournot (“n.v.a.”) 33 31 30 Cournot 25 31 26 Competitive 24 29 24 Actual PJM New England California Price

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Conclusions

• Horizontal structure alone does a very poor job describing

the performance of US markets

• Vertical arrangements + horizontal structure massively

reduces scope for market rules to impact outcomes, appear to explain performance pretty well

• Vertical arrangements are having a big impact on

competition, market rules less so

• Key was that retail prices were constrained, making them

similar to long-term fixed price contracts

– In this case by regulatory transition mechanisms – A similar effect could apply for deregulated retail if retail prices are determined before wholesale prices