Lessons learned from Nordic electricity market liberalization : Competition and regulatory issues

1. Lessonslearned from Nordic electricity market liberalization: Competition and regulatoryissues Einar Hope Norwegian School of Economics and Business Administration ETH Zürich 03.04.08

2. Overview • Some lessons from the Nordic, European and US power market reforms • Special characteristics of electricity in market terms • Market design of organised power markets • Some competition issues: • Potential sources of potential market power • Market design of retail markets and some retail competition issues • Regulation of network infrastructure. Some regulatory issues

4. Some characteristics of electricity as a commodity • Multi-dimensional product: energy(kWh), capacity(kW), voltage, frequency, security of supply, location etc). • Demand elasticity: price, income (short run - long run) • Derived demand. Low energy cost in relation to total cost • Seasonal variations: year, day. Load curves • Capacity adjustments. Hydro, thermal • Long term investments. Generation, network • Self service system

5. Characteristics of electricity markets • Electricity cannot be stored (hydro), homogeneous commodity • Instantaneous balancing of supply and demand by system operator • Very low short run elasticity of demand; also long run; derived demand; price signals with a lag, limited real-time pricing. Also low short run supply elasticity • Capital intensive, lumpy, irreversible and durable investment; fixed cost, sunk cost. Long lead times • Capacity constraints in transmission; the network as a ”market” • Market power issues deriving from characteristics and properties of electricity

6. Figure : Industry cost (supply) curve. The rent concept

7. Figure : Industry cost curve for energy. Merit order system

8. Figure : Marginal cost in a hydro power system

9. Welfare analysis – economic efficiency • Economic efficiency concepts • Static efficiency • Technical efficiency. Productive efficiency • Allocative efficiency • X-efficiency (inefficiency) • Dynamic efficiency • Technological change • Product innovation, etc • Rent seeking • Decomposition of efficiency concepts.

10. Performance criteria: Efficiency dimensions • Static efficiency (operation) • Cost efficiency • Optimal use of total production and grid capacity • Dynamic efficiency (investment/innovation) • Optimal dimensioning of production and grid capacity • Introduction of new technology and products in the value chain (incentives for innovation) • Facilitating market integration; spacially, across energies, and in relation to other products/sectors • Capacity enhancing investment versus investment in flexibility • Security of supply; reliability

11. Figure . Decomposition of efficiency concepts

12. Economic efficiency and market failure • Sources of market failure • Public goods • External effects in production and consumption • Market imperfections • Economies of scale (natural monopoly) • Monopolisation • Lacking markets • Competition monopoly regulations • Imperfect information; asymmetric information • Uncertainty • Market failure in energy markets

13. Some lessons from the reform of the electricity industry • The Energy Act of 1990 in Norway: Establishing electricity markets, common carriage, vertical separation, regulatory system • A common Norwegian-Swedish market from 1996. An integrated Nordic market from 2001 • Considerable gains from deregulation - still a considerable potential, especially in the grid and from further integration of energy markets • Reduction in the general price level of electricity - greater volatility of prices

14. (Cont) • Greater flexibility on the demand side and change of consumer behaviour: New contract forms, price competition, change of supplier, price information systems, risk hedging facilities, customer focus • Entry of new players in the markets: Brokers, traders, clearing companies, retail chains, petroleum companies, financial analysts, international energy companies • New organisational forms: Co-operative and outsourcing arrangements, e.g for power purchasing, invoicing, metering etc. Concern model, horizontal and vertical integration to end-consumers, separation and unbundling of competitive and monopoly functions

15. (Cont) • Ownership structure - cross-ownership, privatisation • Long gestation period for competition in retailing • Inertia and opposition to change from suppliers: Ownership structure, production orientation, market power, political influence. Consumer inertia/local loyalties, inexperienced consumers operating in new markets • Primitive risk hedging facilities and contracts for small consumers (households) - but developing • Regulatory lag - regulatory uncertainties

16. Design of organized power markets • Organized power markets operated by NordPool: • Elspot (physical spot market deliveries) • Eltermin (futures and forward contracts) • Elbas (thermal power adjustment markets) • Eloptions (European and Asian power options) • Design and operation of “green” electricity markets • Markets operated by grid operators: • Regulation Market (Norway/Statnett): capacity market; balance market between real and planned exchange in the delivery phase on short notice (15 min)

17. cont • Elspot: daily trading for delivery next day for each of 24 hours. Price and quantity by noon - market contracts by 2.30 p.m., based on equilibrium price of aggregate supply and demand schedules (system price) • Eltermin: Futures market for hedging of power contracts up to three years ahead. Daily market settlement of the difference between system spot price and contract price. For forward contracts settlement only in the delivery week - no daily settlement

18. cont • Elbas: market for adjusting imbalances for thermal producers in Finland and Sweden after completing their Elspot trade. Continuous trading for single hours up to two hours prior to delivery • Clearing functions: Power Clearing System and Nordic Electricity Clearing (NEC operated by NordPool) of spot and futures contracts. Clearing also of bilateral contracts as of 1998. • Some 280 customers trading at NordPool (power producers, distributors, industrial companies, large retail customers, brokers, traders etc.)

19. cont • NordPool is a non-mandatory pool: around 70 % of total traded volume through organized markets; liquidity and efficiency? • On the whole: a successful market reform: considerable efficiency gains, integration effects and greater flexibility for consumers

26. What went wrong in California? • Electricity industry before regulatory reform in April 1998: • Three large investor-owned utilities (IOUs) • Vertically integrated into generation, transmission and distribution • Significant out-of region energy needed to serve in-state demand. (Ca. 25%) • Retail electricity rates regulated by California Public Utilities Commission (CPUC) • Wholesale prices and transmission tariffs regulated by Federal Energy Regulatory Commission (FERC)

27. Factors contributing to ”crisis” • Small amount of new capacity built in California during 90’s, and also in surrounding states • Higher natural gas prices • Forced outages since summer of 2000 • Price inelastic wholesale demand • Retail price freeze • Few consumers face real-time price • Price cap on wholesale price • Regulatory differences between federal and state (FERC and CPUC)

28. Competition issues: Market power • Definition of market power: • The power to profitably raise the market price above the competitive level • Observations on market power: • Potential market power may or may not be exercised • The Lerner index (price – marginal cost/price) is a measure of exercised market power • Several measurement problems

29. Potential sources of potential market power • Definition of relevant market: Nordic, national, regional, local. Organized markets and total market, including bilateral contracts. Importance of transmission capacity constraints. • Measuring market concentration: Vattenfall ca 50% market share of Swedish market; 20-25% of Nordic market. Many suppliers - low horizontal market concentration • Horizontal and vertical integration: strengthened market position, cross-subsidization, locking-in of customers, price discrimination

30. cont • Composition of energy system: hydro and thermal. Market power in hydro systems. Norway only hydro. Share of hydro power in the Nordic system: around 50% • Demand variations: daily and seasonal peak demand; summer-winter variations • Ownership and incentives: public ownership, cross-ownership, concentration • Capacity constraints in generation: underinvestment?

31. cont • Capacity constraints in transmission and handling of constraints • Asymmetric information: large and small players? • Collusion: tacit or coordinated through transparent markets? • Entry conditions and behaviour: potential competition as disciplining factor • Enforcement of competition policy in electricity markets and design of regulatory system for natural monopolies. Relationship between competition policy and sector-specific regulatory agencies

32. Market power in wholesale markets • As generation and load have to balance in real time, pivotal generators have very significant potential market power • Pivotal generators need not be big (in terms of annual production or market share) • But big generators are pivotal more often than small generators • Thus there is a positive relation between concentration and potential market power in wholesale electricity markets

33. Market power mitigation in wholesale markets • Splitting of major incumbents and reduced barriers to entry • ”More players in a given market” • Integration of previously separated local, regional or national markets • ”Larger market for a given set of players”. (Key issue: interconnector/transmission capacity and pricing • Forward contracting • ”More markets for a given set of players”

34. Best practice, Nordic countries, Wholesale • Market integration and forward contracting: No significant exercise of market power documented • Features of the Nordic market • Interconnector/transmission capacity sufficient for regional price equalisation most of the time (?) • Degree of concentration relatively low • Stringent market rules make relevant information available for all market participants • Significant share of hydro power

35. Some retail market developments • A very transparent market • An increase in the number of suppliers with “external” offers, i.e. outside their concessionary grid area • Restructuring of the retail trade market through mergers and acquisitions; increased regional concentration. Still a considerable number of players. New players entering the market (specialized traders, oil companies, electric appliance chains etc). Some problems with “unserious” entrants.

36. cont • Product innovations, mainly through new contracts • Price discrimination between small and large retail customers. Some suppliers now charge an “administration fee” for small customers to recover some of the switching cost and shift competition to large customers by giving special price offers • Somewhat reduced price spread over time • Retail markets are still national within the Nordic market - no cross-border competition yet

37. Some retail competition issues • Sufficient mobility of retail customers (switching) to sustain effective competition? • Incentive for switching from reduced price spread? • Competition or coordination of prices of suppliers from transparency and frequent exchange of price information (market contact)? • Distribution of transaction costs between suppliers and end-users? • Increased vertical integration in the value chain. Implications for competition?

38. cont • Bundling of products from horizontal integration to other energy forms (gas and district heating), plus ICT products? • Risk hedging contracts - potential for improved contracts for households. Locking-in effects of risk contracts and long-term contracts? • Incentive effects of standardized load profile measurement and charging of customers? • Lowering of grid user prices through more efficient and stronger enforced regulatory regimes

39. Market power in Nordic retail markets • Low barriers to entry suggest that retail markets are ”contestable” • High actual and perceived switching costs may protect incumbents and give them market power • High retail market concentration in Sweden and Denmark

40. The process of benchmarking • Benchmarking: one of several possible methods or instruments for a regulator or a firm to assess the relative performance standard compared to a set of selected observations. • Steps in a benchmarking analysis: • Identify the group of units (firms) for comparison; demarcation of functions • Identify range of potential methodologies • Identify outcome equivalent to best practice • Collect data on a consistent basis • Conduct analysis. Compare own performance with best practice • Plan and implement improvements. Assess outcome and implement corrective measures • Examples of benchmarking from SESSA