Market Power and Market Monitoring

1. Market Power and Market Monitoring 9th Baltic Electricity Market Mini-Forum Dr. Konstantin PetrovSeptember 2009

2. Content • Competition • Market Power • Market Monitoring • Indicators to Measure Market Power

3. Competition

4. Fundamental Price Drivers • Network access • Regulatory uncertainty • Market design • Taxes/Levies/surcharges Regulation End-User Prices Demand • Peak load (MW) • Load growth (MWh) Supply • Fuel prices • Available generation • Available transmission Competition • No straight forward indicator Competition is only one of the factors influencing electricity prices!!!

5. Definition • Adam Smith: "in the sense of rivalry in a race, a race to get limited supplies or a race to be rid of excess supplies". • Marshall: “The strict meaning of competition seems to be the racing of one person against another, with special reference to bidding for the sale or purchase of anything. […] In modern economic theory, a market is said to be competitive, when the number of firms selling a homogeneous commodity is so large, and each firm’s market share is so small, that no individual firm finds itself able to influence appreciably the commodity price by varying the quantity of output it sells“. • Oxford dictionary of economics: “the situation when anybody who wants to buy or sell has a choice of possible suppliers or customers”.

6. Perfect Competition Assumptions: • A vast number of buyers and sellers of the same, homogeneous product • Perfect mobility of people and resources, • Profit-maximising behaviour by producers, welfare-maximising behaviour by consumers • Perfect knowledge by all buyers and sellers of all relevant present and future conditions in all markets • Absence of externalities Characteristics • Each firm sets its price at the level of its marginal costs to maximise its profits • If a firm sets a price above the price of other firms it sells nothing • If a firm sets a price below the other firms’, it will have to supply all of the market demand for the product • If a firm charges less than marginal costs, it will fail to break even for that unit of output • Under perfect competition, marginal revenue equals price and each firm is a price taker

7. Perfectly Competitive vs. Real Markets • According to economic theory, prices in perfectly competitive markets should be equivalent to marginal cost. • In practice, however, prices on power markets sometimes are considerably higher… Price (€/MWh) Supply / sale Demand /purchase Volume (MW)

8. Workable Competition • Perfect competition is well-recognised as unrealistic in real life • The concept of workable competition emerged from literature (Clark, 1940): • “a market where competition is not perfect but allows the different buyers and sellers to choose between a sufficient number of alternatives” or • “workable competition can be defined as the persistent absence of players with market power” • Basic criteria: limited number of suppliers, no large differences between parties, limited barriers to entry, low switching costs

9. Market Power

10. Market Power / Definition • Definition: “Market power is the ability of a firm to profitably raise the price of a product” • Market power exists in nearly every product market • Only perfectly competitive markets exhibit no market power; in all markets, privately-owned firms continually attempt to exercise market power • Prof. Wolak: • Question is not whether or not firms exercise market power • Question is when does the exercise of market power cause significant harm to consumers

11. Technical Characteristics of Electricity Business • Power flows follow the laws of physics • Transport of electricity is constrained (congestion) • Power generation is constrained (ramping rate, black start capabilities, environmental factors) • Storage is extremely limited and expensive • Demand varies each second and need to be balanced instantaneously

12. Economic Characteristics of Electricity Business • Absolute cost advantages of established firms • Techniques • Know how • Research • Consumer loyalty • Capital requirements and funding constraints • Economies of scales • Irreversible commitment

13. Typical Reasons for Market Power • Transmission constraints and market fragmentation • High degree of concentration • Inelastic demand • Peak demand conditions and instantaneous balancing • Strong national incumbents • Joint capital control of generation and transmission capacities • Gaps in market arrangements

14. Bids Bids Price 2 Price 1 Price 1 Volumes Volumes Market Power Strategies - Capacity Withholding Competitive case Capacity withholding

15. Bids Price 1 Volumes Market Power Strategies - Strategic Bidding Competitive case Strategic bidding Bids Price 2 Price 1 Volumes

16. Market Power Determinants • Physical - Generation & Load • Cost, capacities (supply curve) • Ownership structure of generation assets (market share) • Price elasticity of demand • Load profile • Network constraints • Administrative & Regulatory Environment • Type of market - mandatory/voluntary • Existence of bilateral trading, forward contracts etc. • Market entry regime, market monitoring • Horizontal / vertical integration

17. Studies on Market Power • Newbery/Green (1992 and 1995) observed significant exercise of market power in the old E&W Pool (complacent duopoly) • Frank Wolak estimated substantial welfare damage caused by the exercise of market power in California in 2000/2001 • European Commission (Sector Study 2007) concluded unsatisfactory level of competition on EU market due to high concentration and constrained transmission interconnection (market fragmentation) • Von Hirschhausen (2007) observed insufficient competition in the German electricity market (mark-ups > 30 %)

18. Market Power Examples APX, The Netherlands July 2001 EEX, Germany December 2001 • The Dutch regulator and TSO expressed significant concerns in 2001 when huge spikes appeared at APX (up to 1200 €/MWh in single hour) • In Germany, large price spikes appeared at EEX in December 2001

19. 100 90 80 70 60 50 40 30 20 10 0 €/MWh EEX gleitender Monatsdurchschnitt Geschätzte Grenzkosten gleitender Monatsdurchschnitt 2005 2004 21958 h 31.07.2003 30.09.2003 31.07.2005 30.09.2005 30.11.2003 31.01.2004 31.03.2004 31.05.2004 31.07.2004 30.09.2004 30.11.2004 31.01.2005 31.03.2005 31.05.2005 30.11.2005 Market Power Examples Source: Schwarz / Lang 2007 • Schwarz / Lang (2007) shows differences between estimated marginal cost and EEX price in Germany

20. Market Monitoring

21. Objectives • Identify market design flaws or anti-competitive behaviour • Assist the different parties in identifying improvements in market arrangements • Ensure corrective actions • Prevent from future problems • Close monitoring discourage rule violation

22. Scope • Continuous analysis to identify potential problems requiring further study, including design flaws and undesirable behaviour • Investigation of any problems identified by own screening, or in response to complaints from others • Regular reporting on the results of analysis and investigations • Collect and publish other relevant market information • Take corrective actions, initiate / recommend rules changes and other improvements

23. Principles Main principles • Outcome orientation • Customer focus • Proportionality (i.e. being aware of and limiting the regulatory burden) and cost efficiency Additional principles • Consistency over time • Public reporting subject to any confidentiality requirements • Encourage market participants to collaborate with the monitoring activities • Transparency allows other entities to perform their own analyses and contribute to monitoring • Special investigations in response to specific market outcomes and/or events • Avoid regulatory micro-management interfering with normal market outcomes

24. Types of Monitoring Existing market participants Approved Market Rules Compliance Monitoring Are players fulfilling their obligations? Competition Monitoring Are players behaving competitively? Day to day reporting Timeliness and correct format of bids, notifications, reporting rules etc. Prices, volumes, constraints that became binding, incidents Qualitative and informal monitoring Analysis Price trends, incidents, constraints, market structure etc. Measures (discussions, warnings, sanctions) Proposals for change Market structure Market rules

25. Indicators to Measure Market Power

26. Competition Analysis • Study whether market power is exercised or exists • Types of analysis • Structural Analysis • Concentration ratio (CR) • Market Share and Herfindahl-Hirschman Index (HHI) • Residual Supply Index (Pivotal Supplier Indicator) • Behavioural Analysis • Price-Cost Margin Index (PCMI) • Lerner Index (LI) • Simulation Models (competitive benchmark using oligopoly models)

27. Concentration Ratio (CR) • A commonly accepted measure of market concentration • Takes into account the market share of the firms • Measure the concentration of the one (CR1), three (CR3) or five largest companies (CR5) • For monitoring purposes thresholds indicating market power: CR1> 33,3%, CR3 > 50%, CR5 > 66,7 % • Does not assess the behaviour, market power may be exercised in markets with low concentration

28. Herfindahl-Hirschman Index (HHI) • A commonly accepted measure of market concentration • Takes into account the market share of the firms • Approaches zero when a market consists of a large number of firms of relatively equal size • HHI increases both as the number of firms in the market decreases and as the disparity in size between those firms increases • For monitoring purposes usually some indicative limits are used, e.g.: low concentration HHI < 1000, moderate concentration 1000 < HHI < 1800, high concentration HHI > 1800 • Does not assess the behaviour, market power may be exercised in markets with low concentration

29. Characteristics of HHI Highly concentrated Moderately concentrated

30. Characteristics of HHI Moderately concentrated

31. The Herfindahl-Hirschman Index calculates the sum of the squared market shares of all generators in the market and it range From 0 for a perfectly competitive market 0 – 1.000 the market is reasonably competitive 1.000 – 1.800 the market is moderately concentrated 1.800 – 10.000 the market is highly concentrated To 10.000 for a monopoly. 2002 MIN (HHI) = 2.738 MAX (HHI) = 3.914 2003 MIN (HHI) = 1.342 MAX (HHI) = 2.944 2004 HHI in Romania Source: OPCOM

32. Residual Supply Index • A commonly accepted measure of market concentration • Measures the importance of each individual company to meet demand • If RSI higher than 100 %, the residual capacity is enough to cover demand • For monitoring purposes usually some indicative thresholds are used, e.g. RSI should be not less than 110 % for more than 5 % of time (438 hours per year)

33. Price Cost Margin Index and Lerner Index • Commonly accepted measures of competitive behaviour • Takes into account the difference between actual market prices and competitive market price measured by marginal cost • Significant deviations from competitive market prices indicate market power • Difficulties with computation of marginal cost and interpretation of results

34. Defining the Demand Segments Build generation portfolios Production Cost Curve (Estimate system marginal cost) Simulation of strategic behaviour (Gaming) Estimation of the mark-ups for the different demand segments Simulation Models / Approach

35. Simulation Models / Techniques Advantages Disadvantages Cournot (Quantity) Flexible Tractable Important existing literature Little descriptive power Not very realistic (pure quantity bids) Weak predictive power Kahn (1998), Andersson and Bergman (1995), Hogan (1997)Borenstein and Bushnell (1999), Smeers and Wei (1999), Hobbs et al. (2002, 2003), Younes and Ilic (1997), Berry et al. (1998), Stoft (1999), Willems (2002) Flexible Tractable “non-storability“ aspects Not very realistic (pure price bids) Producers have limited capacity Weak predictive power Bertrand (Price) Hobbs (1986), Aghion and Bolton (1987) • More realistic (reflects actual bidding rules) • Allow better understanding of companies’ bidding behaviours • Better predictions Little computational tractability Multiple equilibrium SFE (Supply Function Equilibrium) (Quantity+price) Klemperer and Meyer (1989), Green and Newbery (1992), Bolle (1992), Bohn et al. (1999), Rudkevich et al. (1999), Day et al. (2001), Baldick and Hogan (2001) • Realistic (firms do not sell all their output to the spot market ) • Impact on market power? Requires additional assumptions Forward Contracts Allaz and Vila (1993), Bolle (1993), Powell (1993),Batstone (2000), Newbery (1998) , Green (1999)

36. Long-term planning KEEM, PLEXOS Network Models (Load flow analysis) Balancing market Short-term dispatch and strategic bidding PSS/E, PowerFactory, ELEKTRA KREMLIN PLEXOS, ProSym, SYMBAD Water optimisation SDDP KEMA Market Models Overview

37. Practical Issues • Structural indicators possess low predictability power, market power can exist in market with low concentration • Estimation of marginal cost may be arbitrary: • Large data volumes needed, low data granularity and data gaps • Consideration of start-up cost • CO2 emissions • Mathematical algorithms • It is arbitrary whether (short-term) marginal cost and perfect competition models should be used to set competitive prices • Definition of competitive prices using oligopolistic competition requires different type of modelling and depends on series of assumptions

38. Conclusions • Market power is a major threat on electricity markets • The major question is not whether some companies have market power, the question is whether they abuse it! • Monitoring is necessary to: • Identify market design flaws or anti-competitive behaviour • Ensure corrective actions • Prevent from future problems • There are several good structural indicators (CR, RSI, HHI), however with low predictability power • Behavioural indicators (LI, PCMI) describe better market performance, however difficulties in the computation and interpretation process

39. Many thanks! Dr. Konstantin Petrov Managing Consultant Mobil +49 173 515 1946 E-mail: konstantin.petrov@kema.com KEMA Consulting GmbH Kurt-Schumacher-Str. 8, 53113 Bonn Tel. +49 (228) 44 690 00Fax +49 (228) 44 690 99