Understanding Market Power in Hydropower Sector

1. ECON 4925 Autumn 2006Resource EconomicsMarket power Lecturer: Finn R. Førsund Market power

2. Background • The use of market power is a potential problem of the deregulated electricity sector • 20 % of the world’s electricity is produced by hydropower and 1/3 of the countries have more than 50% • Hydro power is a special case due to zero variable cost, water storage, high effect capacity and maximal flexible adjustment Market power

3. Plan of the talk • The basic hydropower model • Hydropower model with limited reservoir • Hydropower and thermal power • Hydropower with thermal competitive fringe Market power

4. The basic hydropower model • Discrete time periods (weeks) over a natural inflow cycle (one year) Deterministic demand and total water • All inflow occur in the first period, e.g. after snow melting, spring rain, autumn rain • The reservoir limit of the system will not be reached • Zero variable costs in the hydro system • Only variable cost alternative value of water Market power

5. Social utilisation of water • Social planning: maximising sum of consumer plus producer surplus = area under the demand curves • No discounting • Free terminal value of reservoir • Optimal solution: arbitrage price of stock of water (Hotelling); marginal willingness to pay (price) equal for all time periods Market power

6. Problem formulation The Lagrangian First-order condition The monopoly model Market power

7. The monopoly model, Interpretation of the conditions • Maximising profit introduces marginal revenue functions • Marginal revenue can be expressed as demand-flexibility corrected prices • Optimality condition: flexibility - corrected prices equal for all time periods • Market prices will vary with relative elastic periods having lower prices than relative inelastic periods Market power

8. Social optimum, and monopoly Period 2 Period 1 p2(e2H) p1(e1H) p2M p1S= λS p2S =λS p1M λM Market power

9. Spilling and monopoly • Depending on the characteristics of the demand functions it may be optimal for the monopoly to spill water • Spilling can be regulated by prohibition • Zero-spilling regulation will reduce the monopoly profit Market power

10. Spilling and zero-spilling regulation Period 2 Period 1 p1 p2 p2M p1M λ<0 λ<0 Total available energy Market power

11. Limited reservoir and the social solution • Reservoir dynamics: water at the end of a period = water at the end of previous period plus inflow minus release of water during the period • Shadow prices on water and reservoir limit recursively related, solving using backward induction (Bellmann) • Overflow is waste • Social price may vary if reservoir constraint is binding Market power

12. Problem formulation The Lagrangian Limited reservoir and monopoly Market power

13. Limited reservoir and monopoly, cont. • First-order conditions Market power

14. Limited reservoir and monopoly, cont. • The flexibility-corrected price substitute for the social price • Flexibility-corrected prices may differ if reservoir constraint binding • Social solution may be optimal if binding constraint • Differences with social solution depend on the demand elasticities • Spilling may be optimal Market power

15. Illustration of monopoly solutionwith reservoir Period 2 Period 1 p2M P2S p1M p1S p1M λ2M λM λ1M D A B C Spill Market power

16. Hydro and thermal • Thermal plants aggregated by merit order to a convex group marginal cost function • Total capacity is limited • Static problem: no start-up costs, no ramping constraints or minimum time on – off • Shadow price on water equal to flexibility-corrected prices and equal to marginal cost of thermal capacity Market power

17. Problem formulation The Lagrangian Hydro and thermal, the model Market power

18. Hydro and thermal model, cont • First-order conditions Market power

19. Monopoly and extended bath-tub Period 1 Period 2 p2M p1M λM c’ c’ a c A D C B d Hydro energy Thermal extension Market power

20. Hydro with competitive fringe • Thermal fringe modelled by a convex marginal cost function with limited capacity • The fringe is a price taker and sets market price equal to marginal cost • The dominant hydro firm must take fringe reaction into consideration • Market power is reduced due to the fringe • Conditional marginal revenue curve closer to demand curve due to market share less than 1 and fringe quantity adjustment Market power

21. Problem formulation Fringe response Total differentiation Hydro with competitive fringe; the model Market power

22. Hydro with competitive fringe • First-order conditions Market power

23. Hydro with competitive fringe, cont. • Conditional marginal revenue • Closer to the demand function due to • Market share effect • Fringe quantity reaction effect Market power

24. The leader – follower game Period 1 Period 2 p2 θ2 p1 c’ c’ λ λ A B C D E Hydro energy Thermal fringe Market power

25. Extentions • Hydro as competitive fringe • Hydro fringe can release all water just in one period, may restrict market power further • Oligopoly game between hydro producers • Essentially a dynamic game, reduces the possibilities of strategic shifting of water • Quite complex to find solutions to dynamic gaming • Uncertainty • Future water values become stochastic variables, system must avoid overflow or going dry, qualitatively the same problem for social planner and monopoly Market power

26. Conclusions • Hydro monopoly shifts water from relatively inelastic periods to elastic ones • May be difficult to detect because variable cost is zero, only alternative value of water is variable cost and not readily observable • Reservoir constraints, production constraints, etc. reduce the impact of market power • Competitive fringe may block use of market power • Fear of hydro market power exaggerated? Market power