Strategic Behaviour in a Capacity Market? The New Irish Electricity Market Design.

• Author: Teirila, Juha

1. INTRODUCTION

   Following several waves of merger activity since the 1990s, it is not uncommon for restructured electricity markets to be dominated by a small number of large players (Newbery (1995)). This has justified the use of regulatory price caps to protect consumers from the exercise of market power during periods of peak demand. Electricity markets now face the new challenge of responding to countries' ambitious decarbonization objectives (e.g., IEA (2016)). This means growing (intermittent) renewables generation while ensuring security of supply is maintained during the energy transition.

   It has recently been questioned whether an "energy-only" market can guarantee adequate generation. Wholesale price caps that are set too low can lead to a "missing money" problem (Cramton and Stoft (2006), Joskow (2008)), weakening investment incentives. Growing wind and solar generation can exacerbate the adequacy problem by decreasing the run-time of fossil-fuel generation. Uncertainty around government policy--e.g., renewables support mechanisms and the trajectory of carbon prices--is difficult to hedge and can drive up the cost of capital.

   Policymakers and economists increasingly see a market design that combines an energy market with a capacity market as a way to deal with these challenges (e.g., Cramton and Stoft (2006), Joskow (2007), Cramton et al. (2013), Newbery (2016)). (1) Capacity markets have in recent years been introduced in several European countries (e.g., Britain, France) and already exist in regional U.S. markets (e.g., New England, PJM). They allow a government to procure its preferred level of resource adequacy at least cost via a competitive auction; winning generators commit to being available at a future date against an auction-determined capacity payment.

   Our key observation is that the introduction of a capacity auction can give large incumbents an additional lever to exercise market power. Hence the outcome may depart from the least-cost solution--and be unfavourable for electricity consumers. Strategic behaviour can involve withholding capacity (to drive up the capacity payment received on remaining units) or predatory bidding (to induce rival exit from the electricity market). A player's incentive to exert market power in the capacity auction depends on competition in the electricity market, so these need to be modelled jointly.

   In this paper, we present such a model with three components: (1) the electricity market (featuring a small number of strategic players and a competitive fringe), (2) the capacity auction and (3) industry dynamics, i.e., entry and exit decisions. We then present an empirical application to the new Irish Integrated Single Electricity Market (I-SEM), which is due to be implemented in 2018, and present a set of ex ante simulation results. (2)

   The Irish case is interesting for four main reasons. First, a single firm ESB controls 44% of generation capacity (excluding wind farms) so concerns about strategic behaviour are already present. Second, the need to comply with the EU's Third Energy Package means that Ireland is moving from a system of administrative capacity payments to an auction; the committee responsible for the I-SEM's design noted that "The I-SEM capacity market is likely to exhibit structural market power, creating challenges for the design of the auction" (SEM Committee 2016, SEM-16-010, p. 23). Third, the Irish market is salient from a renewables perspective: fast-growing wind generation accounts for the bulk of new investment and over 20% of installed capacity in a system that has traditionally been dominated by ESB's gas-fired generation. Fourth, the I-SEM capacity market will be the first in Europe to feature a design based on reliability options (ROs). (3)

   We quantify the impacts of strategic behaviour by ESB in the capacity market on wholesale prices and buyers' costs of purchasing electricity across a range of scenarios (e.g., different volumes of procured capacity, new entry). (4) We find significant costs of strategic behaviour, even with new entry: In our baseline scenarios, procurement costs in the capacity auction are around 150-400 million EUR (or 40-100%) above the competitive least-cost solution. From a policy perspective, we use the model to analyze the performance of well-known screening tools (e.g., RSI) in measuring market power in the capacity auction, and also explore how auction design can help mitigate market power.

   We find that using a differentiated bid cap for incumbents can partially mitigate market power--but also shifts significant informational requirements back onto the regulator.

   Our paper contributes to the literature on market power in wholesale electricity markets (Green and Newbery (1992), Wolfram (1999), Sweeting (2007) on Great Britain; Borenstein et al. (2002), Joskow and Kahn (2002), Puller (2007), Mansur (2008) on U.S. markets). This work mostly employs competitive benchmark analysis: it derives the competitive outcome via estimates of generators' unit costs and interprets any differences compared to the simulated equilibrium as evidence of strategic behaviour. We extend this literature to the study of market power in the capacity market. We use a Cournot-based model of wholesale electricity market in which the degree of forward contracting serves as an index of competitiveness; higher contract cover pushes the equilibrium price down towards the perfectly competitive level (Allaz and Vila (1993)). (5) A common form of vertical integration--pre-commitments to sell at a fixed retail price--has the same effect. We employ a similar approach to Bushnell et al. (2008), implemented as mixed integer linear programming (Ito and

   Reguant (2016)). (6)

   Our work complements to two recent theoretical papers on capacity markets and market power. Schwenen (2014) uses a simple duopoly model to show how a non-competitive clearing price in a capacity auction "compensates" firms for a loss of market power in the electricity market. Leautier (2016) compares alternative capacity-market designs with a focus on investment incentives, and finds that ROs reduce market power but do not entirely eliminate it. Our analysis quantifes the impacts of strategic behaviour in an empirical context, and also speaks to its policy implications.

   The paper is organized as follows. Section 2 summarizes the context of Irish electricity market design. Section 3 sets out our modelling approach, and Section 4 explains how we implement the model for the Irish case. Sections 5-7 contain our main analysis and results: (i) the two benchmarks of an energy-only market and competitive bidding in the capacity auction, (ii) the quantitative impacts of different forms of strategic behaviour in the capacity market, and (iii) policy options to measure and mitigate market power. Section 8 presents our conclusions.

2. ELECTRICITY MARKET DESIGN ON THE ISLAND OF IRELAND

   This section gives a brief overview of electricity generation on the island of Ireland, and then outlines the key features of the transition from the old to the new Irish market design (SEM and I-SEM).

   Irish electricity generation. Table 1 summarizes the 2015 capacity and ownership structure. Total generation capacity amounts to just over 12 GW. Natural gas is the main fuel, with a capacity share of close to 50%; the second-largest fossil fuel is coal with a share of around 13%. Wind power accounted for more than 20% of capacity. Generation from other sources such as peat, oil, distillates, and hydro pumps plays a more minor role; there is no nuclear power and negligible amounts of solar PV. (7) The largest player ESB owns a substantial 44% of total capacity (excluding wind farms) while two other large firms, SSE and AES, control 14% and 13%, respectively. These three firms are the only ones that hold a diverse portfolio of generating units which uses different fuel inputs. Other players have small market shares and own only a small number of generating units. There are also two 500 MW cross-border interconnectors to the British electricity market: Moyle (between Scotland and Northern Ireland) and the East-West interconnector (EWIC, between Wales and the Republic of Ireland).

   Single Electricity Market (SEM). The SEM was established in 2007 when jurisdictionally separate markets in the Republic of Ireland and Northern Ireland were combined. It is a gross mandatory pool in which the system operator calculates the least-cost dispatch schedule, resolves the System Marginal Price (SMP) for each trading period, and centrally dispatches units. (8) Generators also receive administrative capacity payments to cover their fixed costs; the regulator allocates these across trading periods and generating units. This centralized design is incompatible with the EU Third Energy Package's aim of fully integrating electricity markets according to market-based principles.

   Integrated Single Electricity Market (I-SEM). The new I-SEM market design will differ from the SEM by: (1) introducing forward, day-ahead, intraday, and balancing markets, which are cleared before the physical delivery takes place; (2) implementing a new cross-border power fow algorithm; and (3) replacing the administrative capacity mechanism with a market-based capacity auction. The third change is the motivation for our analysis. (9)

   The new capacity market will be based on auctioned reliability options (ROs). The system operator (SO) purchases ROs from the capacity providers. An RO is a financial contract that entitles the SO (buyer) to receive a difference payment from a generator (seller) if the price in the electricity market exceeds a pre-defined strike price. ROs are backed by physical generation capacity; the SO thus pays the generators an auction-determined price for the sale of an option--a kind of market-based capacity payment. (10) ROs will be sold in an annual uniform price auction. The SO determines the amount of capacity needed...