Market Power in Power Markets: An Analysis of Residual Demand Curves in California's Day-ahead Energy Market (1998-2000).

• Author: Prete, Chiara Lo

1. INTRODUCTION

   Producer market power can be defined as the ability of a supplier "to profitably raise prices above competitive levels and maintain those prices for a significant time period" (U.S. Department of Energy, 2000). A distinction is often made between vertical and horizontal market power. The former is exercised when a firm involved in two different activities in the supply chain (e.g., power generation and transmission) uses its dominance in one area to raise prices and increase overall profits. In liberalized electricity markets, separating ownership of generation, transmission and distribution or requiring transmission owners to give nondiscriminatory access to their transmission systems addresses issues of vertical market power. However, unbundling does not exclude the possibility of horizontal market power, which occurs when a firm is able to affect prices because of concentration in a single step of the supply chain (e.g., power generation).

   In the case of horizontal market power in generation, a supplier could maintain high prices by reducing output below competitive levels (Werden, 1996), or by exploiting the unique characteristics of electric networks, for instance increasing output to create bottlenecks in the transmission system (Cardell, Cullen Hitt and Hogan, 1997). Such exercise of market power could arise as a result of coordinated actions among competing firms (explicit or tacit collusion), or from actions of a single firm directed at profitably influencing market prices (unilateral market power). In a liberalized setting with wholesale electricity markets, generators could influence market-clearing prices by bidding capacity into the market at prices above marginal cost ("economic withholding") or by not bidding available resources in the market ("physical withholding") (Sheffrin, 2001).

   The exercise of market power can have important efficiency implications, as described by Borenstein, Bushnell and Wolak (2002). In the short-run, productive efficiency can be affected: for example, if a supplier exercising market power restricts its output in order to raise prices, smaller players expand generation from more expensive plants in response to the higher prices. In the medium or long-run, when demand is more elastic, market power also has an impact on the level of consumption and creates allocative inefficiencies: the marginal value of the next unit of consumption will exceed the marginal cost of some units of withheld supply. Market power can increase the level of congestion on a network, thereby affecting efficiency and reliability of the system (Cardell, Cullen Hitt and Hogan, 1997). Finally, market power can influence long-term decisions: an increase in power prices should ideally be interpreted as a signal for investors that new capacity is needed, but this may not be the case if market power is being exercised (dynamic inefficiency).

   Several wholesale electricity markets were under intense scrutiny after their creation, due to concern over the potential exercise of horizontal market power (Newbery, 1995; Sweeting, 2007; Wolfram, 1999). Few markets, however, have been studied as extensively as the California one after its debacle in 2000-2001. While most researchers acknowledge that the California electricity crisis resulted from a combination of rising input costs, shortage conditions, flawed market design, exercise of market power and inadequate regulatory response, they do not agree on the relative contributions of these factors. Some analysts (Borenstein, Bushnell and Wolak, 2002; Joskow and Kahn, 2002; Puller, 2007; Wolak, 2003) concluded that prices observed on California's wholesale electricity market departed from competitive levels and marginal generators exercised a significant degree of market power; other authors (Harvey and Hogan, 2000, 2001) suggested instead that flawed market design was the main problem, and factors unrelated to the exercise of market power could have contributed to determining the unusually high level of prices observed between the second half of 1999 and the end of 2000.

   This paper re-examines the issue of the exercise of market power in California after liberalization, with a focus on its day-ahead energy market (the PX) and its five non-utility thermal generators. In the PX energy market, generators typically submitted hourly offers (in the form of a set of monotonically non-decreasing bids) indicating their willingness to supply power at different prices for any or all of the 24 hours in the following day, while load serving entities placed demand bids. Ranking bids in merit order allowed construction of hourly aggregate demand and supply curves; the hourly market-clearing price was then determined by the intersection of aggregate demand and supply. The paper focuses on the five thermal generators that owned assets divested by the former vertically integrated utilities after liberalization: the majority of their generating capacity was represented by natural gas plants and accounted for about 30% of total capacity in California.

   The study contributes to the existing literature on the exercise of market power in California's wholesale electricity markets after liberalization in two ways. First, most previous analyses are based on prices and quantities, together with information on power plant characteristics and generation. This paper relies instead on an extensive database, that includes the hourly energy bids of all PX participants, as well as technical characteristics, power generation and estimated marginal costs of most thermal units owned by the five non-utility generators. The PX hourly bid data is part of a filing made by several California parties at the Federal Energy Regulatory Commission on March 3, 2003 (Docket No. EL00-95, Exhibits CA-270a to CA-270e (Federal Energy Regulatory Commission, 2003a)) and has only been previously examined by Orea and Steinbuks (2012).

   The second contribution relates to the paper's methodological approach. Several studies (Borenstein, Bushnell and Wolak, 2002; Joskow and Kahn, 2002; Puller, 2007) rely on simulation models to derive a competitive baseline, under the assumption that no generator has the ability to exercise market power, and compare simulated prices with actual prices. Other papers (Kim and Knittel, 2006; Orea and Steinbuks, 2012; Puller, 2007) estimate market power through conduct parameters. This analysis is based on the combination of a measure of each firm's incentive to exercise unilateral market power and first order condition checks. Each firm's incentive is measured by the absolute value of the inverse elasticity of the hourly PX residual demand faced by the firm, evaluated at market-clearing price. (1) Given the residual demand elasticities, we obtain the firm's hourly marginal revenues: these can be compared to market-clearing prices and estimated marginal costs of production to assess whether, on average, the five thermal generators in the PX were exercising unilateral market power, behaving competitively or restraining quantities relative to the level implied by Nash supply function competition.

   The paper is organized as follows: Section 2 presents an overview of California's deregulated electricity market and describes the two market institutions that managed grid operations and the trading of electricity and ancillary services (the PX and the ISO). Section 3 reviews the literature on the exercise of market power in California after deregulation. Section 4 describes methodology and data of this paper, Section 5 presents the results and Section 6 contains concluding remarks.

2. CALIFORNIA'S WHOLESALE ELECTRICITY MARKET IN 1998-2000

   For nearly a century, electricity in California was provided by three investor-owned utilities (IOUs) that operated generation, transmission and distribution facilities: Pacific Gas & Electric (PG&E) in northern California, Southern California Edison (SCE) and San Diego Gas & Electric (SDG&E) in the southern part of the state. The state was highly dependent on power imports, which represented roughly 20% of its supply, and had high retail electricity prices. In an attempt to create a more competitive and lower cost electricity system, in 1992 the California Public Utilities Commission initiated a market review process, which led to Assembly Bill 1890 in 1996 and the opening of a restructured electricity market in April 1998.

   The IOUs were required to provide open access to their transmission and distribution system, and to divest most of their fossil-fueled generation capacity (mainly powered by natural gas) to five private firms (Duke, Dynegy, Reliant, Mirant and AES Williams). (2) By the end of the divestiture process, the five firms had approximately the same size and owned nearly 17,000 MW, representing about 30% of the total electricity generation capacity in California.

   Moreover, two new institutions, the California Power Exchange (PX, or CalPX) and the California Independent System Operator (ISO, or CaISO), were created to manage the operations of the grid and the trading of energy and ancillary services. The PX operated the day-ahead and hour-ahead energy markets, designed as two-sided uniform price auctions, (3) and acted as a Scheduling Coordinator (SC--an intermediary for transactions between generators and load serving entities responsible for submitting balanced energy schedules to the system operator). (4) The ISO managed transmission congestion and monitored the hourly acquisition of four ancillary service products (regulation, spinning reserves, non-spinning reserves and replacement reserves), both day-ahead and hour-ahead. In addition, the ISO operated a real-time energy market, in which deviations between predicted and actual supply and demand were balanced in real time. The real-time energy market was also designed as a uniform-price auction: a generator supplying more than its day-ahead energy schedule (or a load...