Outline of Talk Market Power in Utility Industries Definition of - PowerPoint PPT Presentation

Outline of Talk Market Power in Utility Industries • Definition of Market Power Presentation at 2004 Australian Competition and Consumer – Market Power versus Market Manipulation Commission Conference on “Evaluating the – Cost of Market Power Effectiveness of Regulation” • Market Power Problem in Utility Industries • Methods for Measuring Unilateral Market Power Frank A. Wolak – Application to Generic Industry Department of Economics • Measuring Market Power in Electricity Markets Stanford University – Ability to exercise market power Stanford, CA 94305-6072 – Incentive to exercise market power wolak@zia.stanford.edu • The impact of forward contracts • Application to California Electricity Market http://www.stanford.edu/~wolak • Measuring the Cost of Market Power Chairman, Market Surveillance Committee – Application to California Electricity Market California ISO What is Market Power? What is Market Manipulation? • No definition under US antitrust law • Ability of a firm to • Whether a firm engages in market manipulation depends on – Increase the market price your perspective – Profit from this price increase – Market manipulation as seen by one player is superior business – Both are necessary for firm to possess market power acumen as seen by another • A firm exercising all available unilateral market power • In markets where this concept exists, market operator defines subject to the market rules is equivalent to what constitutes market manipulation – The firm maximizing profits, which is equivalent to – Commodity markets—operator prohibits corners, squeezes, etc. – The firm’s management serving its fiduciary responsibility to its – Usually requires a finding of intent shareholders • Same action without intent may not be market manipulation • The issue for regulatory oversight is not whether a firm • Suggested definition of market manipulation for electricity possesses market power or exercises this market power markets – Particularly in a bid-baseed electricity market determining whether a – Persistent actions by one or more market participants that harm firm possesses unilateral market power is relatively straightforward system reliability or market efficiency • Key issue is whether the unilateral exercise of market power • Requires a finding of intent by market operator results in market outcomes that cause sufficient harm to • Implies need for long, involved legal process—Microsoft trial consumers to justify regulatory intervention 1

Structural Measures of Market Power Structural Measures of Market Power • Market power cannot be assessed based on • In utility or network industries, concentration indices market structure alone miss key features which enhance ability of firms to exercise unilateral market power – Using concentration measures to assess market – Level of final demand power exposes consumers to large potential harm – Extent that final demand is price inelastic • Particularly in network industries – Need for dedicated and potentially congested network to • Standard indices of concentration deliver product to final consumers – Cost of storing final product – Hirshman-Herfindahl Index (HHI) = n 2 ∑ si • Electricity is costly to store, natural gas and water less expensive – s i = market share of firm i = i 1 – Extent of capacity constraints in production • Measured using capacity, sales, or units of output • Can produce only slightly more than 500 MWh from 500 MW unit • These features of industry determine how much • Large values imply significant market power unilateral market power a firm can exercise and how – HHI denotes market-wide market power much harm this causes to consumers – Market share denotes firm-level market power Market Power and Network Industries Utility Industries and Market Power • Bottleneck network facility is fundamental source of market power and need • New entry ultimately limits the exercise of market power for unique regulatory oversight of utility industries • In utility industries, long time lag between decision to enter and start of operation by new facility can cause significant harm to consumers • Production technology implies that least-cost way to serve market demand is • Time lag between conception and start of operation for a new natural gas-fired single network facility for a given geographic area facility is at least 18 to 24 months in the United States – Electricity—transmission and distribution network – Can be even longer for coal-fired facilities – Natural Gas and Water—distribution network • Substantial amounts of market power can be exercised over the time horizon – Postal Delivery Services—Local delivery network necessary for new entrants to begin producing output – Telecommunications—Local loops – Forward prices of energy in California during winter/spring of 2001 • Difficult to see how competition would be possible in transmission and • ~$300/MWh for summer 2001 deliveries distribution services for same geographic region for electricity and for • ~$150/MWh for summer 2002 deliveries distribution services for natural gas and water • ~$45/MWh for summer 2003 and beyond deliveries – Market power expected to exist until significant new entry could discipline behavior of • If there are viable alternatives to bottleneck facility, then utility or network existing suppliers industries would no longer present unique market power problems relative to • Similar logic applies to telecommunications network other industries – Incumbent could exercise significant market power before competing network is built out – Telecommunications is closest to eliminating essential bottleneck facility – Prices that reflect incumbent’s market power would provide strong incentives for • Wireless, cable television and electricity network are, to varying degrees, competitive competitors to enter alternatives to local loop of incumbent telecommunications carrier for last-mile access • In both cases, regulatory intervention to limit market power may be preferable to consumers – Depends on cost of intervention 2

Measuring Unilateral Market Power Residual Demand Curve faced by Firm • An essential input for measuring firm-level unilateral market power is firm’s residual demand curve Price Price – The slope of the residual demand curve measures how much the firm is able to increase the market price by unilaterally D(p) SO(p) withholding output from the market • A firm’s residual demand curve is the market demand curve less the competitive responses of other firms in DR(p) = D(p) - SO(p) the industry – D(p) = market demand a price p – SO(p) = supply of all competitors at price p – DR(p) = D(p) – SO(p) = residual demand curve at price p • The firm’s profit is given by – Π (p) = DR(p)p – C(DR(p)) Quantity Quantity – C(q) is the total cost of producing output level q Measuring Unilateral Market Power Pricing to Maximize Profits Subject to Residual Demand • Given market demand, D(p), and willingness to supply of competitors, SO(p), a profit-maximizing firm would set p to satisfy (p* – C’(q*))/p* = -1/ , (p*), where q* = DR(p*) , (p) = DR’(p)*(p/DR(p)) = elasticity of residual demand curve at price p • A profit-maximizing firm would like to set monopoly price for its residual demand curve • -1/ , (p) = inverse of elasticity of residual demand curve at price p • -1/ , (p) = percent increase in market price that results from one percent reduction in firm’s output at price p • Measuring market power would be straightforward if could observe the residual demand curve firm faces 3