Exercising unilateral market power in the wholesale electricity market

1. Exercising unilateral market power in the wholesale electricity market Briefing to MEUG on Wolak Methodology Johannah Branson,4 June 2009

2. Purpose of briefing Wolak’s conclusion: Four largest suppliers to NZ’s wholesale electricity market have, at times, had substantial ability and incentive to exercise unilateral market power By increasing or reducing their offer prices to raise or lower market-clearing prices Earning them large market power rents in the wholesale market over several sustained periods Commerce Commission’s conclusion: Suppliers have exercised market power, but no evidence that for any anti-competitive purpose 2

3. Purpose of briefing Briefing: Explain Wolak methodology (for non-economists) Explain New Zealand results Identify potential concerns on applicability to New Zealand (initial comments) 3

4. Context

5. Main report • Wolak (2009) An Assessment of the Performance of the New Zealand Wholesale Electricity Market • Report to Commerce Commission • Public version released 19 May 2009

6. Wolak’s work for Commerce Commission Three phases: Qualitative study on design and performance of NZ electricity market (completed December 2006) Quantitative analysis of performance of wholesale market (current report) Quantitative analysis of performance of retail market, including effects of vertical integration (halted) 6

7. Wolak’s work for Commerce Commission Purpose of quantitative analysis: To investigate whether any market participants have a substantial degree of market power If so, to investigate whether these market participants have taken advantage of this market power 7

8. Traditional approach Built on standard models from economic theory Need to know or assume characteristics of: Market demand (e.g. price elasticity) Firm-level costs (e.g. form of marginal cost curve) Strategic interaction between firms (e.g. behaviour in imperfectly competitive markets) Findings of empirical analysis – conditional on assumed economic models If assumptions not applicable, findings may be incorrect 8

9. Alternative approach Bid based wholesale electricity markets Data rich – opportunity to investigate market power from actual data, without assumptions of traditional approach 9

10. Wholesale market in New Zealand Bid based market Market participants submit willingness-to-sell and willingness-to-buy curves to market operator Each curve shows quantity that a market participant is willing to sell or buy at each possible price Market operator uses all curves to compute market-clearing price and quantities sold and bought by each market participant at this price 10

11. Wholesale market in New Zealand Optimises allocation to serve total demand at lowest total cost Allowing for transmission losses between supply and demand locations Locational marginal pricing/nodal pricing – prices differ between locations due to transmission losses (persistent) and transmission congestion (very infrequent) 11

12. Wholesale market in New Zealand Large number of mostly small consumers Small number of large suppliers So main competition concern is market power of suppliers in influencing market prices 12

13. Wolak methodology

14. Alternative approach Only economic assumption: Firms seek to maximise profits Supplier constructs its willingness-to-supply (offer) curve to maximise its expected profits given the offers of its competitors and bids of demanders 14

15. Summary Framework: Residual demand curve faced by a supplier = bids of all demanders minus offers of other suppliers Supplier constructs offer curve to maximise expected profits given the residual demand curve it faces Maximises profits by supplying quantity at which marginal revenue = marginal cost Where one unit more would cost more to produce than the additional revenue it would earn; one unit less would reduce revenue by more than it would save in costs 15

16. Summary Therefore profit maximising price-quantity combinations on offer curve depend on supplier’s marginal cost curve and residual demand curve So can use suppliers’ offer curves and system demand: To identify for each supplier whether it could increase profits by increasing or decreasing quantity supplied To measure each supplier’s ability and incentive to exercise unilateral market power 16

17. Summary Market power: If a market participant can take unilateral actions to influence the market price and to profit from the resulting price change Firm is only serving its “fiduciary responsibility to its shareholders to take all legal actions to maximize the profits it earns” Ability to exercise – whether a supplier is able to influence the market-clearing price by raising or lowering its offer prices Incentive to exercise – whether doing so would increase its profits 17

18. Main steps Main steps: Residual demand – facing a supplier Elasticity of residual demand – ability to exercise market power Simultaneous offers and bids – uncertain residual demand Fixed-price forward market obligations – incentive to exercise market power Pivotal suppliers – more extreme ability and incentive Regression analysis – relationships with prices Market power rents – the impact of higher prices 18

19. Residual demand First step: Aggregate offer curves across all suppliers: Price and quantity steps Offered by each supplier For one of the 48 half-hour pricing periods of the day Subtract offer curve of one supplier (e.g. Meridian) to give offer curve of all suppliers except this one Compare with level of demand Level of demand minus total offer curve of all suppliers except this one gives residual demand curve facing this supplier 19

20. Residual demand 20

21. Residual demand 21

22. Residual demand 22

23. Residual demand Residual demand curve: Shows quantity that this supplier could sell at each price given the offer curves of its competitors Reflects supply response of competitors and demand response of demanders Gives set of feasible price-quantity combinations that this supplier can choose from to maximise its profits Intercepts with offer curve at market-clearing price 23

24. Residual demand 24

25. Elasticity of residual demand Next step: Calculate inverse elasticity of residual demand curve Indicates how much this supplier could increase market price by reducing the quantity it offers: E.g. if this supplier could have increased market price by 108% by reducing its quantity supplied by 15% Inverse elasticity = 108%/15% = 7.2 Shows tradeoff between higher system price and lower quantity from this supplier because of higher supply offered by its competitors at higher prices 25

26. Elasticity of residual demand 26

27. Elasticity of residual demand Provides measure of ability to exercise unilateral market power: Higher inverse elasticity of residual demand: Indicates greater ability to unilaterally change the market price Due to smaller supply response from competitors Lower inverse elasticity: Indicates less ability Due to larger supply response from competitors 27

28. Simultaneous offers and bids Next step: Offers and bids are submitted simultaneously Market demand and other suppliers’ offer curves are uncertain at time supplier submits own offer curve But supplier does have good idea of likely set of possible residual demand curves: Set of possible offer curves from each supplier is constrained by characteristics of each generation plant and market rules Offer curves can be changed up to two hours before trading period, by which time system demand is fairly certain 28

29. Simultaneous offers and bids So this supplier formulates its offer curve: To supply the profit maximising quantity (where marginal revenue = marginal cost (MC)) Under each of the possible residual demand curves it’s likely to face (DR1, DR2, etc) 29

30. Simultaneous offers and bids 30

31. Simultaneous offers and bids Inverse elasticity of residual demand influences supplier’s offer curve through profit maximising quantity: Steeper residual demand: Smaller supply response from competitors Greater ability to unilaterally change market price Price (offer curve) much higher than marginal cost Flatter residual demand: Larger supply response from competitors Less ability to unilaterally change market price Price (offer curve) closer to marginal cost 31

32. Simultaneous offers and bids Flat (perfectly elastic) residual demand: Sufficient competition that change in quantity has no affect on market price Price (offer curve) = supplier’s marginal cost 32

33. Fixed-price forward market obligations Next step: Bring in fixed-price forward market obligations Under vertical integration, generators sell to: Wholesale market at short-term market-clearing prices Wholesale market through fixed-price forward contracts Retail customers at retail prices that don’t vary with half-hourly prices in wholesale market – pre-committed to fixed-price retail load obligations Supplier’s net position influences its incentive to exercise unilateral market power to change price 33

34. Fixed-price forward market obligations Net long: Energy available to sell > fixed-price forward market obligations (contract + retail) Residual demand net of forward market obligations = positive Net seller to short-term market Incentive to raise market price: Increases cost of fixed-price forward market obligations Increases revenue from sales to short-term market if rise in price outweighs fall in quantity Net gain if increase in revenue from short-term market > increase in cost of fixed-price forward market obligations 34

35. Fixed-price forward market obligations Net short: Fixed-price forward market obligations > energy available to sell Residual demand net of forward market obligations = negative Net buyer from short-term market Incentive to lower market price: Reduces cost of fixed-price forward market obligations Reduces revenue from sales to short-term market if fall in price outweighs rise in quantity Net gain if reduction in revenue from short-term market < reduction in cost of fixed-price forward market obligations 35

36. Fixed-price forward market obligations Without fixed-price forward market obligations: Lower profit maximising quantity at higher price Higher offer curve Further from marginal cost With fixed-price forward market obligations: Higher profit maximising quantity at lower price Lower offer curve Closer to marginal cost 36

37. Fixed-price forward market obligations Provides measure of incentive to exercise unilateral market power: Depends on exposure to fixed-price forward market obligations Calculate inverse elasticity of residual demand curve net of forward market obligations: Higher inverse elasticity of net residual demand indicates greater incentive to unilaterally raise the market price Can be zero – if short-term market sales = fixed-price forward market obligations Negative if fixed-price forward market obligations > short-term market sales 37

38. Pivotal suppliers Next step: Identify pivotal suppliers (can be more than one) Provides additional measure of more extreme ability and incentive to exercise unilateral market power Does aggregate willingness-to-supply of all other suppliers reach capacity before system demand met? If so, supplier is “pivotal” – regardless of its offer price, system needs at least some of its supply This supplier’s residual demand curve becomes perfectly inelastic at pivotal supply 38

39. Pivotal suppliers 39

40. Pivotal suppliers If pivotal: Supplier has ability to set market price as high as wishes, if willing to sell only pivotal quantity But may not have incentive – if fixed-price forward market obligations > pivotal quantity, supplier is a net buyer Net pivotal: If pivotal net of fixed-price forward market obligations Has ability, but also very strong incentive to exercise unilateral market power Greater incentive the larger its net pivotal quantity 40

41. Pivotal suppliers Whether pivotal: Uncertain at time supplier submits offer curve More likely when unexpectedly high demand or large generation or transmission outage Supplier’s strategy: If submits offers as if isn’t pivotal, but is – lost opportunity to exploit market power If submits offers as if is, but isn’t – zero sales Estimates probability of being pivotal Calculates offer curve to maximise expected profits given probabilities and payoffs of being/not being pivotal 41

42. Regression analysis Next step: Run regressions to test relationships between measures of ability and incentive to exercise market power and actual offer prices Controlling for exogenous factors such as daily changes in input fossil fuel prices and water levels Test null hypothesis that thermal generation suppliers are behaving as if had no ability to exercise market power 42

43. Market power rents Final step: Calculate competitive benchmark prices if no market power (by four different approaches) Compare with actual market prices Multiply price differences by quantities supplied to give measures of market power rents earned by suppliers from wholesale market Run regressions to test relationships between measures of ability and incentive and measures of market power rents 43

44. Where else used Established, widely recognised approach (first published in late 1990s) Same or similar methodology used around the world to assess market power in wholesale markets for electricity USA: All wholesale market monitoring agencies Federal Energy Regulatory Commission (wholesale market regulator) California market Pennsylvania-New Jersey-Maryland (PJM) Interconnection market (merger analysis) Colombia Australia (merger analysis) 44

45. Where else used Europe: European Commission’s Directorate General of Competition (2007 report on performance of six European wholesale electricity markets) Germany Spain Denmark UK (underway) 45

46. Results

47. New Zealand application Applies methodology to: Data on half-hourly offer curves and market-clearing prices and quantities Over 1 Jan 2001 to 30 June 2007 For four largest suppliers in NZ wholesale market 47

48. Summary General findings: NZ’s four largest suppliers have some ability to exercise unilateral market power When have ability, are successful in raising market-clearing prices by increasing their offer prices Sometimes have ability but no incentive to exercise unilateral market power When have both ability and incentive, canexercise unilateral market power by raising or lowering their offer prices and thereby market-clearing prices Whether raise or lower prices depends on their fixed-price forward market commitments relative to sales into short-term market Earns them large market power rents in wholesale market over several sustained periods 48

49. Ability Inverse semi-elasticity of residual demand: Measure of ability to exercise unilateral market power Shows $/MWh increase in market-clearing price associated with a 1% reduction in supplier’s quantity Approximated from step functions by examining window to either side (e.g. price +/-10%) 49

50. Ability Inverse semi-elasticities: Over sample period and by time of day Similar pattern for each of the four suppliers Persistently higher for some suppliers – Meridian highest, Mighty River Power lowest Average across four suppliers – high positive correlation with market-clearing prices Mid-2001, early 2003 and early 2006 – high ability, high price 2002, 2004 and 2005 – low ability, low price 50