Competition Policy and Regulation in Hydro-Based Electricity Markets

1. Competition Policy and Regulation in Hydro-Based Electricity Markets Luiz Rangel Energy Centre, University of Auckland September 2007

2. Introduction • Traditionally, energy economics literature focuses on static models. • Adequate for representing thermal systems, but hydro is dynamic. • Different technologies correspond to different incentives and methods of exploiting market power.

3. Introduction • Key market power issue: strategic allocation of a given amount of output across periods • Rather than a straightforward reduction of total output (as in thermal systems).

4. Market power: sources and facilitating factors • Factors that constrain firm’s ability to unilaterally affect the market price: • Demand substitutability • Supply substitutability • Potential competition

5. Market power: sources and facilitating factors • Factors limiting demand substitutability • Use of smart/real-time meters still limited • Consumers therefore do not react to changes in real-time prices • Less of a problem in hydro-based systems, since strongest price fluctuations are from season-to-season or year-to-year. • Long-run elasticity higher than short-run elasticity

6. Market power: sources and facilitating factors • Factors limiting supply substitutability • Generation capacity constraints • Hydro plants are less often capacity-constrained than thermal plants • Competition policy analyses should give attention to type of technology of competition

7. Market power: sources and facilitating factors • Factors limiting supply substitutability • Transmission capacity constraints • May be more of a problem in hydro systems: plants have to be built where the resource is, requiring transmission

8. Market power: sources and facilitating factors • Factors limiting supply substitutability • Technological constraints • Unit-commitment problem: ramping rates, start-up and shut-down costs • Hydro plants are more flexible and can respond more quickly to price changes • Once again, competition policy analyses should take into account the type of technology of competitors

9. Market power: sources and facilitating factors • Factors limiting potential competition • High fixed costs and long lag periods • Forecasting about the timing of recovery of capital costs can be more complex • Best hydro sites already occupied • Environmental regulations/resource consent

10. Strategic allocation of water • First papers from O.R. literature: Scott and Read (1996), Kelman, Barroso and Pereira (2001) • Crampes and Moreaux (2001) and Bushnell (2003) • Hydroelectric resources smooth the price profile in a perfectly competitive environment; in contrast, strategic hydro generators tend to sharpen the peaks.

11. Strategic allocation of water • Bushnell (2003): even though peak loads are higher in June than in September, price distortions are actually less dramatic in June, when more water is available. • Mathiesen, Skaar and Sørgard (2003): the reallocation of hydro output is actually related to relative demand elasticities, rather than demand levels.

12. Strategic allocation of water • Garcia, Reitzes and Stacchetti (2001): Price-caps affect prices even when the cap is not binding • Price-caps therefore play an even stronger disciplining role in hydro-based markets compared to thermal-based markets • Likelihood of collusion increases with reservoir levels and the probability of water inflow: punishment becomes more credible

13. Interaction with transmission constraints • Borenstein, Bushnell and Stoft (2000) • Static (one-period) model • How are things different in hydro systems?

14. Interaction with transmission constraints • Johnsen (2001) • Firms have excessive incentives to export energy early on, so that storage is below the socially optimal • Increasing transmission capacity may actually be detrimental to competition!

15. Interaction with transmission constraints • Skaar and Sørgard (2006) • Cross-regional mergers/acquisitions in hydropower markets with transmission bottlenecks • Mergers may increase social welfare, even if no efficiency gains • Firm will internalize detrimental effects of congestion on the exporting area

16. Effects on system reliability • Garcia, Reitzes and Stacchetti (2001) • Conditions under which hydro replaces thermal • If price caps are set too low, reliability is compromised: the value of holding onto water will be low, so hydro producers will undercut thermal producers

17. Effects on system reliability • Garcia, Reitzes and Stacchetti (2001) • What if different plants face different hydrological conditions? • Firms with greater probability of replenishment may have either a higher or lower opportunity cost of selling power in the current period • If higher opportunity cost, reliability may be compromised!

18. Some conclusions and policy implications • A merger between two generators who operate well below capacity most of the time should be viewed with greater care than a merger between two generators that operate at or near capacity • A merger between two generators with flexible production technologies (reservoir hydro) should raise more concern than a merger between two generators with inflexible technologies (thermal)

19. Some conclusions and policy implications • Mergers between generators located inside the same load pocket deserve more care than mergers between generators located in different geographic areas • A merger between generators that are close to each other in the merit order is more problematic than a merger between generators with very different marginal costs