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First Lecture: Part 2 Strategic Evolution of Competitive Electricity Markets Derek W. Bunn London Business School

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The globalisation of energy markets is having an effect on price convergence Global Markets for Fuels: Oil, Coal, LNG Global Energy Businesses replacing National Utilities International Capital Markets and Multinational Investors Market Liberalisations and Harmonisations Regional Interconnections But rather less than we would expect

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EU Industry Prices still show substantial disparity..

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So, what do we now know about the evolution of power markets? 1.Dynamic Evolution Initial thoughts that global markets would be a strong convergent driver have not been upheld: Local Factors, Market Structure and Strategic Behaviour may be more important.

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Local Fundamentals: 1. Link to fuels UK Monthly Forward Prices

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Local Fundamentals: The Supply Stack Links Fuels to Prices The Stack is produced from the Generators Offers to the market But would the Generators offers be cost reflective?

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Time Weighted Average Monthly Pool Prices 24 Average Price Cap Notice the High Volatility During the Price-Cap Period.

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The Increase in Price Volatility...

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. was achieved through changing the supply function.

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Local Fundamentals: 1. Link to Fuels 2. Supply and Demand Balance

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Sensitivity of Prices to Reserve Margin

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Deregulation California Reserve Margin Declined Steadily. Margin %

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WSCC CAL Hourly wholesale power prices ( $/MWh ) And at a critical point, spikes began to emerge

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Local Fundamentals: Fundamental link to Fuels Reserve Margin Market Structure and Conduct New Game

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Changing Ownership of Coal (ie price-setting) Plant (Source: John Bower)

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The Growth of Vertical Reintegration

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Residential Wholesale Vertical Integration Immunised against Wholesale Price Full Retail Opening Price Index

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Value moved to the Least Elastic part of the Supply Chain Prices Paid for Residential Assets (/Domestic Customer)

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With a Drop in Value of Generating Plant CCGT Resale Prices /kW

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Re-Concentration follows distress

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90% of Retail now delivered by Top 6 Suppliers Source: Power UK March 2005

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65% of England and Wales Generation Produced by Top 6 Suppliers Source: IPA Energy

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Prices Moved Up

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Large Generators Returned some Capacity

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These Basic Divers Appear in Price Models Fundamental link to Fuels Reserve Margin Market Structure and Conduct Eg. Monthly Price Model (1990-2002) by Evans & Green Price (Lerner) = a + b1 Herfindahl + b2 Herfindahl2 + b3 Demand/Capacity + b4 Sept2000 (R2 = 67%) And their effects are Cyclical

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What do we now know about the evolution of power markets? 1.Dynamic Evolution Initial thoughts that global markets for fuels would be a strong convergent driver have not been upheld: Local Factors, Market Structure and Strategic Behaviour may be Pro-cyclical. 2.Value can migrate up and down the supply chain Retail can capture value more effectively than wholesale

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What do we now know about the evolution of power markets? 1.Dynamic Evolution Initial thoughts that global markets for fuels would be a strong convergent driver have not been upheld: Local Factors, Market Structure and Strategic Behaviour may be pro-cyclical. 2.Value can migrate up and down the supply chain Retail can capture value more effectively than wholesale 3.Governments are beginning to prefer imperfect markets A few large, vertically integrated companies provide security and can be managed.

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. and many countries explicitly pursue the national champion objective. EU GENERATION CAPACITY CONCENTRATION RATIO (3 FIRM) 2001

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What do we now know about the evolution of power markets? 1.Dynamic Evolution Initial thoughts that global markets for fuels would be a strong convergent driver have not been upheld: Local Factors, Market Structure and Strategic Behaviour may be pro-cyclical. 2.Value can migrate up and down the supply chain Retail can capture value more effectively than wholesale 3.Governments are beginning to prefer imperfect markets A few large, vertically integrated companies provide security and can be managed. 4. Imperfect Markets will exhibit Dynamic Strategic Behaviour Prices will not stabilise at marginal costs

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Even after 7 years of daily evolution, the supply function was not stable.

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The following days continue to show dynamic learning and gaming.

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What do we now know about the evolution of power markets? 1.Dynamic Evolution Market Structure and Strategic Behaviour may be Pro-cyclical. 2.Value can migrate up and down the supply chain Retail can capture value more effectively than wholesale 3.Governments are beginning to prefer imperfect markets A few large, vertically integrated companies provide security and can be managed. 4. Imperfect Markets will exhibit Dynamic Strategic Behaviour Prices will not stabilise at marginal costs 5. Regulatory Risk is inevitable and substantial

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Further Reading: Sally Hunt Making Competition Work in Electricity (Wiley, 2002) Steven Stoft Power System Economics (Wiley, 2002) Alexander Eydlund and Krzysztof Wolyniec Energy and Power Risk Management (Wiley, 2003) Derek Bunn Modelling Prices in Competitive Electricity Markets (Wiley 2004)