How to Make Competitive Network
Industries Benefit Consumers
Frank A. Wolak
Department of Economics
Stanford University
Stanford, CA 94305-6072
[email protected]
http://www.stanford.edu/~wolak
Chairman, Market Surveillance Committee
California ISO
Outline of Talk
• Regulation versus competition
– Costs versus benefits
• Essential role of retail market
– Difficulty with hybrid markets
• Greater need for explicit protection of lowincome consumers
– Financial and informational assistance
• Changing role of regulator under competition
Regulated Monopoly
• Benefits of vertically-integrated monopoly
– Economies to scale in production
• Technology is such that 1 percent increase in inputs
causes greater than 1 percent increase in outputs
– Extensive network necessary to deliver product
• More than one network raises average costs
– Lost economies of scale and scope
– Single firm under government control makes it
easier to pursue policymaker’s goals
• Can maintain cross-subsidies across services
Regulated Monopoly
• Costs
– Although the potential exists for the monopoly
to realize economies to scale and scope
• Reward structure due to regulatory process gives
little incentive for least-cost production
• Political environment firm operates in makes leastcost operation just one of many goals
• Conclusion--Least-cost production does not occur
and limited economies to scale and scope are
realized
Regulated Monopoly
• Major problem with regulation
– Firm usually knows its technological capabilities and the
demand that it faces better than the regulator
– This leads to dispute between firm and regulator over
minimum cost mode to serve demand firm faces
– Regulator can never know minimum cost of providing service
– There are laws against confiscating regulated firm’s assets
• Impossible to tell difference between regulator setting
– Output prices that confiscate firm’s assets
– Output prices that provide strong incentives for least-cost operation
– Long history of legal disputes in US that attempt to define
process for setting prices that do not confiscate firm’s assets
– Firm understands value of superior information about its
demand and technology in regulatory price-setting process
Regulated Monopoly
• Costs (continued)
– Monopolist has little incentive to provide
diversity of products consumers desire
• Purchase good offered by monopolist or nothing
– Monopolist has little incentive innovate to
reduce costs or discover superior good
• Innovation takes effort, but cost reduction is
immediately reflected in lower rates
• Monopolist may be happy with “quiet life”
Regulation versus Competition
• Benefit of competition
– There are no laws against a firm’s competitors confiscating the
firm’s assets through their output and pricing decisions
• Any firm that is unable to cover its costs at the price set by market will
exit industry
• Nature of competition among firms leads high cost firms to exit the
industry and be replaced by lower cost firms
– Contrary to regulated regime, no need to determine if a firm’s
incurred production costs are the least-cost mode of
production
• If market is competitive, then any firm that is able to remain in
business must be producing at or close to minimum cost
– Possibility of exit from industry provides strong incentives for
minimum cost production under competition
Competitive Market
• Benefits
– Privately-owned, profit-maximizing firm has a
strong incentive to produce at minimum costs
• Any cost reductions not duplicated by competitors
translate one-for-one into higher profits
– Privately-owned, profit-maximizing firm has a
strong incentive to innovate
• Any cost reduction not duplicated by competitors
yields higher profits
– New investment decisions based on market price
• Purely economic basis for new investment
Competitive Market (Benefits)
• Economies to scale and scope are less
relevant than in early stages of industry
– Technological change allows smaller minimum
efficient scale of production
– Large market demand relative to smaller
minimum efficient scale of production
– Conclusion--modest or no economies of scale or
scope over relevant range of output
• Strong incentive to provide diversity of
products consumers demand
– Profitable niche markets
Competitive Market
• Costs
– Firms in a competitive market have little incentive
to pass on cost reductions to consumers in the form
of lower prices
– Firms exercise all available unilateral market power
• Same as serving fiduciary responsibility to shareholders
• Actions can set prices far in excess of competitive levels
• Existing firms may takes actions to prevent entry by new
firms
– Competitive markets make it virtually impossible to
maintain cross-subsidies in prices across services
and/or consumers.
Regulation versus Competition
• When minimum cost of providing service is known,
little reason to run a market for service
– Cost-of-service regulation can be used to set price
• When minimum cost of providing service is unknown,
run a market to determine this cost
– Competitive markets provide strong incentives for minimum
cost production
– Not necessarily strong incentives to pass-on lower costs in
lower prices--market power problems
• Unless potential for significant cost reductions exist,
introducing competition makes little sense
Pricing Under Competition Versus Regulation
Price
TRCompetition = A + B
MC
TRRegulation = A
PCompetition
B
A
Qd
Quantity
Pricing Under Competition versus Regulation
Price
TRCompetition = A + C
MCRegulated
TRRegulation = B + C
B
PCompetition
MCCompetition
A
C
QCompetition
Quantity
Regulation versus Competition
in Electricity Supply
• Technology for delivering electricity implies
– One transmission and distribution grid needed for a given
geographic area
– Competition among multiple networks would lead to single
dominant network
• Large fixed cost to construct network
• Close to zero marginal cost to operate
• In all regimes, monopoly supplier of transmission and
distribution services for each geographic area requires
government oversight
– Unregulated monopoly can set prices for use of network that
extracts all monopoly profits from electricity supply
Regulation versus Competition
in Electricity Supply
• In competitive generation regime, unregulated
monopoly supplier of transmission and distribution
services can set prices for use of network that results in
monopoly price for delivered electricity
– Price of transmission and distribution services must be set by
independent regulator or government
• In vertically-integrated monopoly regime, unregulated
firm can set monopoly price for delivered electricity
– Output price of vertically-integrated monopoly must be set
by independent regulator or government
• Both regimes require regulation of some services
Regulation versus Competition
in Electricity Supply
• Competitive regime restricts regulated portion of
industry to smallest entity possible
– Transmission and distribution are only regulated services in
competitive regime
– Generation and electricity retailing are open to competition
• Regulated regime imposes regulatory process on all
aspects of industry
– Final output price of vertically integrated monopoly is
regulated
• Choice between regulation and competition depends on
which regime yields lower prices to consumers
Regulatory Reasonableness Problem of
Retail Rates
Maintaining single monopoly retailer of electricity in
competitive generation regime implies that regulator must
continue to determine prudence of all energy and ancillary
services purchases
Regulator must run an energy trading firm to determine prudent forward
versus spot market purchases by monopoly retailer
Regulator must avoid significant temptation to second-guess itself after
the fact if spot price is significantly below forward contract price
Extremely difficult, if not impossible, for regulator (or any other entity) to determine if
forward contracting behavior was prudent ex post
Consumers comfortable with buying price insurance that is ex post unprofitable.
Regulators are not so comfortable.
Why Retail Competition is Essential
When minimum cost of providing service or product is
unknown, run a market to determine this cost
Competitive markets provide strong incentives for minimum
cost production
Minimum cost of procuring wholesale energy and ancillary
services is unknown and extremely uncertain
A market is needed to find this minimum cost and determine
which firms are good at this and which are not
Retail competition provide natural mechanism to pass on
wholesale price increases and decreases
Role of Retail Competition
• Pass-through of wholesale price signals
– Retail competition is most politically viable way to accomplish this
– Regulator has very hard time raising retail price even with huge observed
run-up in wholesale price
– Privately owned profit-maximizing firm as very little problem raising
retail prices if wholesale prices rise
• Hedged consumers win, consumers on spot market lose
• If spot price falls, opposite result occurs
• Retail competition can provide full diversity of product offerings
(pricing and reliability options) consumers demand
– Competition provides strong incentives to serve all profitable niche
markets
– Consumer has choice among products offered by all competitors
– Can purchase lighting, heating, cooling needs from separate providers
• To do this requires real-time metering for each service
• Can only bill consumer for unit of time or at service that you can measure
consumption
Retail Competition Requires Facing Consumers
with Real-Price Risk
• Currently amount fixed-price customers pay to retailer for
energy annually is expected to cover total annual energy costs
• This is true whether or not consumer is exposed to real-time
price risk
• Mandatory exposure to real-time price risk gives customer the
option to make forward contract commitment to receive fixed
retail price or manage price risk for lower average price
• Analogous to purchasing airline 3 weeks in advance with Saturday
night stay-over
• If purchase ticket at last minute someone must face spot price risk
• Unless require forward hedging--this will be retailer,
• This creates potential for unhedged wholesale spot price above fixed
retail default provider rate
• Only mandatory exposure to real-time price risk with ability of
consumers to hedge this price risk solves this problem
Involving Final Demand
• All customers must eventually face real-time price risk
• Otherwise full benefits of competition will not be realized
• Customer has option of fixed retail price by hedging real-time price risk
through long-term commitment (annual cell phone price plans)
• Real-time pricing should be default for all large customers
• Customers with sophistication to manage price risk
• Requires real-time metering technology
• Residential and small business customers should transition to
real-time pricing scheme
• At start of market set fixed-price default provider rate using vesting
contract wholesale price plus stranded asset recovery rate
• Default provider rate should be set to give customers incentive to take
on real-time price risk
• All retailers must offer fixed-price default provider rate, but they can
also offer any other pricing plan
The Role of High Prices
• Involving demand in the market requires longlived, irreversible investments
• Without constant threat of high prices demanders
will not make necessary investments
– Don’t save any money from investment
– May be cheaper to work to continue price caps
• Carrot and stick approach by regulators
– Carrot--subsidies to early adopters of demand
response technologies
– Stick--promise of removal or lifting of safety
nets in future
Real-Time Pricing not Time-of-Use Pricing
Consumers must pay hourly wholesale price in
hourly retail rate
Time-of-use pricing provides limited signals to
consumers to respond to real-time wholesale
prices
Time-of-use pricing creates the same basic
incentives as fixed-rate billing scheme
Time-of-use pricing may not yield lower average
spot electricity prices or increase incentives for
generators to sign low-priced forward contracts
Time-of-use pricing creates similar incentives to
those from load-profile billing
Load-Profile Billing
• Measure total monthly consumption of electricity
• Representative load shape used to compute weighted-average
energy price for month
– p(h,d) = price for hour h of day d,
– w(h,d) = weigh for hour h of day d,  w(h, d )  1
h ,d
– Monthly bill = (monthly consumption) x (monthly
weighted-average energy price).  w(h, d ) p(h, d )  p
h ,d
• Demand reduction when hourly energy
price is $0/MWh leads
to same monthly savings as same demand reduction when
hourly price is $250/MWh.
• Want consumer to realize maximum benefit from reducing
consumption when wholesale price is highest
– Imagine difficulty in running competitive long-distance telephone
company only measuring minutes of phone use per month
Robust Retail Competition Requires
Real-Time Metering
• Without real-time metering, competition takes place on one
dimension
– Monthly average price
• Recall that conventional meters only measure total monthly
consumption of electricity
• Firms have no idea who in a given customer class is more
expensive to serve in terms of wholesale energy costs
• No surprise there is little retail competition
• With real-time meters competition can take place on
– (hours of the 24)*(Days of the Month), p(h,d) = price for hour h of day d
– May not need all of these dimensions, but with widespread real-time
metering there will be robust retail competition
• Recall dimensions that service measurement in telephony
Real-time pricing contracts
• All England and Wales retail customers have option to
purchase hourly consumption according to hourly pool
price plus transmission charge
• Many large industrial customers purchase according to this
pool price contract
• “Estimating the Customer-Level Demand for Electricity
Under Real-Time Market Prices” Patrick and Wolak
• Estimate half-hourly price responsiveness of a sample of
large industrial and commercial customers in England and
Wales
– Significant price response from all classes of industrial customers-water suppliers, industrial process plants, retail stores
Limited Benefits of Restructuring
Without Involving Demand
• US has privately-owned, profit-maximizing
firms facing cost-of-service price regulation
or incentive regulation plan
– Detailed prudence review of investment
– Hard to argue there are large deviations from
minimum cost production
– Vertically integrated ownership and centralized
dispatch should be able to improve on bid-based
dispatch on true production cost basis
Markets use prices to allocate
scarce resources
• Competitive market should be able to get by with
lower level of capacity and serve same customers
– This implies lower capacity costs for market at
large
– If dispatch costs are close to the same, then
average price in competitive market should be
less than average price in regulated market
• A necessary condition for this to occur is a
sufficient number of price-responsive consumers
Optimal Capacity Choice Under
Regulation versus Competition
Kreg >> Kcomp
Example--US Airline Industry
• Load Factors = (Seats Filled)/(Seats Total),
– In regulated regime highest load factors
approximately 55% in 1976
– Currently Load Factors are close to 73%
• This increased capacity utilization rate
allows real average fare per passenger-mile
to be significantly less than under regulated
regime
• Regime works because of large number of
sophisticated price-responsive consumers.
Implications for Re-structuring
• For consumers to benefit from a
competitive market they must face to realtime hourly price signals
• In competitive market a firm must make
profits on each customer
• Regulated firm only needs to make profits
across all customers
• All customers with same cost to serve will
face same price in competitive market
Implications for Re-structuring
• Inability to cross-subsidize under competition
– Requires greater attention to protecting lowincome consumers from high prices that may
impoverish them
– Regulator may need to require explicit subsidies
• Regulator must provide significantly more
information to consumers to help them
protect themselves
– Emphasize importance of hedging spot price risk
– Information on load-shifting technologies
New Role of Regulator
• Solve Market Design Problem
– Set number and size of market participants
– Set rules for determining revenues each firm
receives
– So that combined actions of each participant acting
in its own best interest
– Yields market outcomes as close as possible to
regulator’s desired outcome
• Political constraints often imposed on process
– Difficult to break-up incumbent monopolist
Restructuring Process
• Requires far more sophisticated regulator
– Regulating a vertically-integrated monopoly
• Determine prudently incurred costs of production
• Set output prices to allow recovery of these costs
– Set just and reasonable prices
– Regulating a competitive market
• Determine market rules that result in competitive
market outcomes
– Determine just and reasonable market rules
• Regulatory rules can give enormous competitive
advantages to some market participants
– Regulator must explicitly account for this regulatory
decision-making process
Restructuring Process
• Regulator must be very suspicious of the
impact of rule changes on market outcomes
– When firm asks for market rule change regulator
should perform following thought experiment
– How could this proposed rule change be used by
firms in the market to increase their profits and
therefore raise prices paid by consumers?
– In competitive market it very hard for a regulator
to make a firm to do something that is not in
firm’s financial interest
Competition Can Benefit Consumers
• No free lunch
– Benefits from re-structuring must come from a
change in behavior of market participants
– Firm operate more efficiently
• Short-term operation at least cost
• Investment decisions based on market signals
– Consumers make greater effort to use existing
capacity more efficiently
• Get by with less capacity to serve same number of
consumers
• Holding excess capacity is costly, because capital
costs of unused capacity must be paid for regardless
What is Market Power?
• Ability of a firm to increase the market
price and profit from this price increase
• In all markets, firms continually attempt to
exercise market power
• Desire to serve interests of shareholders =>
maximize profits => exercise all available
unilateral market power
• Competitiveness of market judged by how
fast potential or actual competitors and/or
consumers respond to foil these attempts
Measuring Market Power
• Market power cannot be assessed based on
market structure alone
– Concentration measures can be misleading
• Whether market power is possessed by a
market participant is not a yes/no decision
– All players possess some market power
– At issue is how much market power is too much
• In bid-based electricity market can compute
explicit measures of market power
– Price elasticity of residual demand
Residual Demand Curve
Price
Price
QD
SO(p)
DR(p)=Q - SO(p)
D
Quantity
Quantity
Profit-maximizing behavior implies an
optimal bid price above marginal cost
• Residual Demand Curve unknown at time
generator submits bids
– Demand uncertainty
– Uncertainty about actions of other suppliers
• Optimal bid curve depends on distribution
of elasticities of residual demand function
• Hourly variable profits of firm as a function of
market-clearing price, P:
B(P) = DR(P)(P - MC)
Best-Response Price (PB) Given Residual Demand Curve
P
PB
MC
DR(p)
Q
S
MR
Best-Response Supply Curve (S(p)) for Uncertain DR(p,)
Price
S(p)
P1
P2
MC
Q2
Q1
MR2
DR2
Quantity
MR1
DR1
Market Power in Spot Market
• If one firm is large enough to affect price, it has
an incentive to restrict output or raise its offer
price on marginal units of output in order to
raise the market price on all units
• A producer may not have to be very large to do
this in electricity markets because:
– Period-level demand elasticity close to zero
– Very high cost of storage
– Strict capacity constraints on production
Market Power with Inelastic
Aggregate Demand
Qd
Price
.
1
2
3
4
5
6
7
8
9
10
Ten Equal Size Firms
Quantity
All Firms Are Pivotal
Price
DR()
Quantity
Pivotal Bidder
• Residual demand faced by Firm A is positive
for all prices
– In this case, Firm A is called a pivotal bidder
– Mathematically, DR() > 0
• Given bids of other firms, at least DR()
from Firm A is required to satisfy market
demand
• Extreme case of market power
– No matter how high a price Firm A bids for
DR(), it will set market-clearing price
– In all electricity markets, there are system
conditions when some firms are pivotal
Market Design Goal
• Make spot market residual demand curve
perceived by all unit owners as elastic as
possible
– Generators facing infinitely elastic residual demand curve
perceive themselves as being unable to impact the market
price by their bids
– Optimal strategy for generation unit owner facing
infinitely elastic residual demand curve is to bid marginal
cost curve as willingness to supply curve
– This will lead to market prices as close as possible to
market designer’s optimum
Financial hedge contracts
Forward financial contracts exert a major impact of bidding
behavior in electricity spot markets
Forward financial contracts are
1) Bet between seller (usually generator) and buyer (usually
load-serving entity) on spot price
2) Number of units of bet taken is contract quantity
Two-sided forward contract or contract for differences (CFD)
pays out
(P - PC)QC to buyer of contract (amount can be positive or
negative)
Impact of hedge contracts on spot market bidding behavior in
Australian Electricity Market studied in
Wolak (2000) “An Empirical Analysis of the Impact of Hedge Contacts on Bidding Behavior
in a Competitive Electricity Market,” International Economic Journal, Summer, 1-40.
Two-Sided Hedge Contract Payments Streams
Price
2
Payments to Purchaser of Hedge
Contracts by Generators at
2
PM
PM
PC
Payments to Generator by Purchaser
of Hedge Contracts at
1
PM
1
PM
QC
Quantity
Bid-Based Market with Hedge Contracts
In NEM1, each day d is divided into the half-hour load periods i.
Qid: Total market demand in load period i of day d
SOid(p): Amount of capacity bid by all other firms besides Firm A into the
market in load period i of day d as a function of market price p
DRid(p) = Qid - SOid(p): Residual demand faced by Firm A in load period i
of day d, specifying the demand faced by Firm A as a function of the
market price p
QCid: Contract quantity for load period i of day d for Firm A
PCid: Quantity-weighted average (over all hedge contract signed for that
load period and day) contract price for load period i of day d for Firm
A.
MC: Marginal cost of producing a MWH by Firm A
id(p): Variable profits to Firm A at price p, in load period i of day d
Bid-Based Market with Hedge Contracts
SAid(p): Bid function of Firm A for load period i of day d giving the
amount it is willing to supply as a function of the price p
The market clearing price p is determined by solving for the smallest price
such that the equation SAid(p) = DRid(p) holds.
The magnitudes QCid and PCid are set in advance of day of bidding.
Generators sign hedge contracts with load-serving entities for a pattern of
load throughout the day, week, or month, for an entire or fiscal year.
Variable profits (profits excluding fixed costs) to Firm A for load period i
during the day d at price p as:
Bid(p) = DRid(p)( p - MC) - (p - PCid)QCid
Unless its bidding strategy can effect the market-clearing price p, Firm A’s
profits are unaffected by its bidding strategy given PCid and QCid.
Best-Reply Bidding with Hedge Contracts
Best-reply bidding strategy–daily bid function, SAid(p),
(i=1,…,48) which results in market-clearing prices that
maximize expected profits..
Let i equal shock to Firm A’s residual demand function in
load period i
Two possible sources of residual demand shocks:
1) Uncertainty in competitors bids–SO(p,)
2) Uncertainty in market demand–Q()
Can be vague about source of error because of partial
equilibrium view
Re-write Firm A’s residual demand in load period i accounting
for this demand shock as DRi(p,i).
Best-Reply Bidding with Hedge Contracts
pkj = daily price bid for increment k of genset j
qikj = quantity bid for increment k of genset j in load period i
1 = ( p11,..., pJK, q1,11,...,q11.JK, q2,11,...,q2,JK, ..., q48,11,...,q48,JK )
=
the vector of daily bid prices and quantities submitted by Firm
A.
Let SAi(p,1) equal Firm A’s bid function in load period i as
parameterized by 1, which is of dimension 48x10J + 10J
for NEM1.
Market rules require SAi(p,1) to be non-decreasing in p.
Best-Reply Bidding with Hedge Contracts
pi(i, 1) = the market-clearing price for load period i given the residual
demand shock realization, i, and daily bid vector 1.
Solution in p to the equation DRi(p,i) = SAi(p,1).
Let f() = the probability density function of  = (1, 2,..., 48)N.
E(()) = expected daily profits from bidding strategy 
Firm A’s best-reply bidding strategy is the solution in 1 to the following
optimization problem:
max E(())
subject to bU $R1 $ bL.
Requires solving over a 3,000 variable nonlinear programming problem.
Best-Response Pricing with Hedge Contracts
Re-write variable profit per period for demand shock i as:
Bid(p, i) = DRid(p i)( p - MC) - (p - PCid)QCid.
= DR(net)id(p i)( p - MC) + F
where DR(net) = DR(p) - QC and F = (PC - MC)QC
Let pi*(i) the value of p that maximizes Bid(p, i).
This is Firm A’s best-response price.
Best-response price may not be attainable given best-response
bidding by firm, but it does give maximum ex post profits
available to firm
Best-Response Prices with Contract Cover
P
PB
NC
B
PC
MC
DR(p)
SC-Q
SNC
SC
C
MR C
MR NC
Q
DR(p)-QC
More Contract Cover than Spot Sales
P
B
PNC
MC
B
PC
SC - QC
S NC
MRC DR(p)-Q C
MR NC
SC
Q
DR(p)
Vesting Contracts
• Vesting contract is an obligation to sell a significant
fraction of a unit’s output at regulated price for at least
two years
– For a 500 MW unit, typical vesting contract would require
selling 400 MW every hour for two years for a pre-specified
price or pattern of price
• Provides wholesale price certainty for load-serving
entities
– Regulator can credibly set a fixed retail price for small
business and residential customers for at least two years
• Ratepayer’s actually paid for incumbent utility’s assets
– Should be given right to receive share of output at “just and
reasonable” price
Role of Vesting Contracts
• Vesting contracts shrink size of spot market
– Only deviations from contract quantity, QC, are bought or
sold at spot price
– Send price signals necessary to attract additional supply and
for demand to reduce consumption without having to pay spot
price for all units produced and consumed
– Contract price has no effect on firm’s bidding behavior in spot
market
• Forward contracts help solve unverifiable forced outage
problem
– Firm obligated to sell QC at PC whether or not it provides any
energy from its own facilities
– Strong incentives to keep facilities in top operating condition
Role of Forward Contracts
• Forward contracts give loads upper hand in bargaining
process with generation for supply of electricity
– At all time horizons up to time necessary to construct new
facility, generation unit owners knows they face competition
only from existing suppliers
• Depending on current supply demand conditions due to planned or
forced unit outages, there may be no limit on bid prices existing
generators can submit and be paid
– At forward contract horizon greater than time necessary to
build new plant--say, two years--all existing generation unit
owners face competition from new entrants
• All loads can buy energy at long-run average cost of supply using
forward prices for input fuels from new entrants
• Above logic underscores importance of streamlining regulatory
process for shortest possible time to site and build power plants
Role of Forward Contracts
• Residual demand curve faced by all suppliers (existing
and potential) at time horizon longer than time
necessary to construct new facility
• Infinitely price elastic (horizontal) at long-run average cost of
production of electricity if no barriers to constructing new capacity
• Implication--Forward market at this time horizon is
extremely competitive
• Residual demand curves existing firms face become
steeper the shorter time horizon to delivery becomes
• If spot market aggregate demand is perfectly inelastic
– Hedge this demand in long-time-horizon forward market or
severe market power problems can arise in spot market
– Australian experience--see Wolak (2000)
Real-Time Pricing (RTP) Increases
Spot Market Competitiveness
• RTP creates a final demand that responds to
hourly wholesale prices, just like generation
• Demand is equivalent to negawatt
generating facility with financial interest in
reducing wholesale energy prices
• Only time lag to obtaining this negawatt
generating facility is time to install realtime metering--can be done very quickly
• Faces all generation unit owners with more
price-elastic residual demand curve
Role of Regulatory Intervention
To Mitigate Market Power
• Permanent regulatory intervention should take
place only in forward market
– Recall that contract price has no impact spot market
bidding behavior
• Can cap or set contract price with not effect on spot price signals
• Easy to set contract price through regulatory process
– Time lag between price setting process and delivery of energy
– Availability of forward prices for input fuels
– Shrink size of spot market and regulate forward price,
PC, to just and reasonable level
– Allow price spot to attract supply and signal demand
reduction
Bid and Price Caps to Mitigate Market Power
• Bid and price caps on spot market eliminate
incentives to invest in solutions to market power
– No risk of high prices implies little incentive to forward
contract or invest in demand-responsiveness technology
• No cost-savings in the form of avoiding high spot prices
– Dulls incentives for investment in new capacity
• Price and bid caps once implemented can never be
lifted because conditions necessary for their
removal will never come about
• Price caps and bids caps have enforcement problem
if generation unit owners are free to export
– Sell outside of control area in forward market and ISO must buy back
above cap in real-time or else rolling blackouts will occur
Bid and Price Caps to Mitigate Market Power
• If implemented, bid and price caps should only be used for
very short-term emergency situations
– Give market time to implement changes to market rules
• Set finite end date for price cap at date of implementation
• Credibility problem with finite end date argues against its use
– Difficult to set price cap at level that limits market power
• Future demand conditions unknown
• Spot price of input fuel paid by marginal unit in future unknown
• Future outage levels are unknown
• All price caps on spot market must necessarily be very high
• Cost-based bid caps with market-clearing price implies
overpayment by consumers
Pricing Under Competition Versus Regulation
Price
TRCompetition = A + B
MC
TRRegulation = A
PCompetition
B
A
Qd
Quantity
Price
Price
QD
Q (p)
SO(p)
D
DR(p)=Q (p)-SO(p)
D
DR(p)=Q - SO(p)
D
Quantity
Quantity