Competitive Assessment of the Energy Market in New England

1. Competitive Assessment of the Energy Market in New England Presented to: Restructuring Roundtable David B. Patton, Ph.D. Independent Market Advisor May 10, 2002

2. The report is a companion to the Peak Pricing Report issued last fall, and responds to concerns raised by NECPUC and the New England Board. The analysis in this report complements the analysis in the report produced by Bushnell and Saravia. The Report provides an assessment of competition in the New England energy market, which includes analysis of: Economic Withholding; Physical Withholding; Other factors that may have artificially raised prices. The analysis includes a detailed evaluation of the high priced hours during Summer 2001, focused primarily on the 15 hours priced at $1000 per MWh. Purposes and Objectives

3. Based on economic theory, the most critical factors affecting incentives to withhold resources are: The sensitivity of prices to withholding (i.e., In absence of demand elasticity, the slope of the supply curve). The size of the participant. The following figure shows why the demand level is critical. Because the sensitivity of prices rises dramatically under the highest demand, the analysis focuses more heavily on these conditions. A workably competitive market where suppliers seek to sell more (i.e., withhold less) in higher demand periods when prices are highest; A market with significant market power issues where suppliers’ incentives to withhold rises in higher demand periods; Competitive Incentives and Load Levels

5. The analysis in the report seeks to determine whether strategic withholding has occurred by examining the correlation of participants’ actions with the market factors that can create the incentive to withhold. This assessment is necessarily an on-going examination that is not limited to the analysis presented in this report. The report also examines the importance of other factors on potential withholding, including: Participant size, Out-of-merit dispatch, Unit types, and Changes in market rules. Summary of Withholding Analysis

6. Economic Withholding:Output Gap Analysis

7. Economic withholding is evaluated by calculating an “output gap” for each hour. The output gap is the difference in each hour between the actual output of a unit and the output that would occur under competitive bids. Reference prices are the competitive benchmark used to estimate the output gap. Price-takers in a competitive clearing-price market will bid their marginal cost. A proxy for generators’ marginal costs can be estimated by averaging the accepted bids for the resource over the previous 90 days. Output Gap Analysis

8. The following chart examines 2001 results for small participants (< 1200 MW) and large participants (> 1200 MW) under increasing demand levels. These results show: The output gap falls as demand rises to super-peak levels – supports workable competition hypothesis. The output gap quantities detected in the peak demand periods are relatively small – less than 1 percent of the market capacity. These results show that the output gap for large participants is generally smaller at each of the load levels and close to zero in the super-peak periods. Output Gap Analysis

10. The output gap values in 2001 after the implementation of three-part bidding are lower than those in 2000 when some bidders may have reflected start-up and no-load costs in their bids. The average output gap for units generally dispatched in-merit is substantially lower than for other units – resources dispatched out-of-merit face different incentives than in-merit resources. The output gap for non-fossil resources is higher than for fossil resources – primarily due to the opportunity costs facing hydro resources. Other Output Gap Findings

11. Physical Withholding Analysis

12. The report analyzes potential physical withholding by examining patterns of forced outages and other deratings (excluding long-term outages and planned outages). The following figure summarizes this analysis, showing that: Total outages and deratings are smallest under the highest demand conditions, which is consistent with a workably competitive hypothesis. The forced outages rise under peak conditions, which may be explained by the higher stress placed on units during high demand periods. The deratings are also evaluated at the participant portfolio level by size of participant – shown in the following figure. Analysis of Physical Withholding

14. The deratings are also evaluated at the participant portfolio level by size of participant in the following figure, showing that: The level of deratings is lower for large participants at all load levels, which may indicate an efficiency advantage of managing a large portfolio. The total deratings for large participants decrease in the highest demand hours, which is consistent with workable competition. Forced outages rise under peak conditions for both small and large participants, but more slowly for the large participants. There is little significant evidence that capacity was strategically withheld, but it is possible that some of the increase in forced outages under peak conditions could be strategic – physical audits of the forced outages remains warranted. Outages and Deratings by Participant Size

16. Regression analysis allows an analyst to determine whether statistically significant relationships exist between a number of factors, isolating the individual effects of each one given the others. This allows a more meaningful assessment of the various factors and their relationship to the size of the output gap and deratings. The regression analysis performed on the output gap and derating quantities yields results that are consistent with the descriptive results presented above. Regression Analysis