By John Kelly Presented at the 27 th USAEE/IAEE North American Conference Houston, Texas

1. Are Price-Cost Markup IndexesReliable Indicators of the Competitiveness of Wholesale Power Markets? By John Kelly Presented at the 27th USAEE/IAEE North American Conference Houston, Texas September 18, 2007

2. MMU’s Price-Cost Markup Index (PCMI) • Brief Background of PJM and its MMU • Why Question of Reliability of PCMI is Important • MMU Definition, Use, and Interpretation of PCMI • Limitations of PCMI as Indicator of Industry Competitiveness • Conclusions

3. PJM Interconnection, L.L.C. • For Year 2006: • Region included more than 51 million people in all or parts of states • Averaged installed generating capacity of 162,571 megawatts (MW) • More than 450 market buyers, sellers and traders

4. PJM Interconnection, L.L.C. • Operates a centrally dispatched wholesale electric power market in all or parts of: Delaware, Illinois, Indiana, Kentucky, Maryland, Michigan, New Jersey, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, West Virginia and the District of Columbia

5. PJM Market Design • … Intended “to promote competitive outcomes derived from the interaction of supply and demand in each of the PJM markets.” • “…Is the primary means of achieving and promoting competitive outcomes in PJM markets.”

6. What PJM does about Market Power • Focuses on market designs that promote competition (a structural basis for competitive outcomes) • Limits direct mitigation of market power to instances where the market structure is not competitive and where market design alone does not mitigate market power.”

7. PJM Market Monitoring Unit • Functions: • Assesses the state of competition in markets operated by PJM; • Identifies specific market issues – such as flaws in market design; • Recommends actions to improve the competitiveness and efficiency of PJM markets. • Publishes an annual state of the market report

8. PJM Market Monitoring Unit • Goal: “The ultimate goal … is to determine whether market outcomes are competitive.” • Claim: “… Rigorous and comprehensive analysis”

9. MMU Analysis of Competitiveness • For Year 2006 Concluded: • PJM Energy Markets were Competitive. • “While the market structure does not guarantee competitive outcomes, overall the market structure of the PJM aggregate Energy Market remains reasonably competitive.”

10. MMU Analysis of Competitiveness • Indicators Employed: • Market size • Concentration • Residual supply index • Price-cost markup • Net revenue and prices • Three pivotal supplier test

11. MMU Analysis of Competitiveness • Indicators Employed: • Market size • Concentration • Residual supply index • Price-cost markup* • Net revenue and prices* • Three pivotal supplier test *Measure MMU says is particularly Important

12. MMU Price-Cost Markup Index • Presents PCMI as measure of market power but does define as Lerner Index– as such; • Often discusses PCMI in language suggesting it is percentage markup over costs: P-C/C; • Marginal Cost estimates include a 10 percent markup over costs

13. Goals of MMU Markup Analysis • (1) “…Calculate actual markups by marginal units,” and to • (2) “…Estimate the impact of those markups on the difference between the observed markup price and the competitive market price.”

14. Conclusions of MMU from Analysis of PCMI Values for 2006 • “… The markup measure results are strong evidence of competitive behavior overall and competitive performance overall in the PJM energy market.”

15. Lerner Index • Index of Degree of Monopoly Power Defined as: P-C/P • Where: • P = price or average receipts • C = marginal cost • Note: -- (1) Measure applies to firm or industry -- (2) Index values range from 0 to 1

16. MMU Price-Cost Markup Index • PCMI applies to marginal generating units and not to firms or industry, as Lerner index does Consequently, it is not clear what is being measured • Defines PCMI ranging from -1 to +1 • MMU does not corroborate results with profit measures that are used in economic literature (latter used because of practical difficulties in calculating LI)

17. Estimated Values of PCMI (for 2005) Load Weighted SourceAnnual AverageRange PJM (System Avg.) 0.3% -4.8 to + 6.7% 3.9 -0.7 to + 10.4 LEI Estimated: (Peak& Off-Peak) Regions Penelec, etc. -3 to +25 % Meted, etc. -1 to +15 B&GE/Pepco, etc. -1 to +17 AEP/PECO, etc. 3 to +19 DPL 2 to +26

18. Practical Limitations of Lerner Index • Basic Problems of Calculating and Interpreting Summary Measures of Almost Any Economic Variable or Concept (i.e., matching economic concepts to available data) • For Example: “Lack of marginal cost data often leads to the substitution of a profit rate for the Lerner index in empirical studies.” (Formby and Layson)

19. General Limitations of Lerner Index • Edward Chamberlin • Does not measure anything beyond the effectiveness of existing substitutes • Gives no indication of potential substitutes – e.g., the important problem of entry • Neglects non-price issues • Consequently – Gives not indication of degree of oligopoly

20. General Limitations of Lerner Index • Chamberlin: • “…Indices of monopoly “merely reduce parts of a complicated problem to quantitative expression.” • Economic indices are limited in their meaning and require further interpretation, especially in relation to one another.

21. Conclusions 1. MMU’s price markup analysis is neither “comprehensive” nor “rigorous;” 2. The analysis has serious conceptual and practical flaws; 3.Consequently, as presently formulated, the analysis does not provide “strong evidence of competitive behavior” in PJM energy markets.