The rationale for a market monitoring process

David NewberySoutheast Europe Electricity Market

Monitoring Workshop Athens 4-5 October 2005

http://www.electricitypolicy.org.uk

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Outline

• Liberalisation and the importance of effective competition– the need for market monitoring

• Tools for market monitoring• Institutional and data issues

Liberalisation and the importance of effective competition

The need for market monitoring

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Energy Liberalisation• Energy critical for economic success• effective competition can

– encourage cost reduction to increase profit– pass on cost reductions to consumers

• Productivity gains from well-designed restructuring and privatisation are impressive– often rapid doubling of productivity

• But consumers can lose if competition weak

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Financial years April-March

Index numbers (log scale)

79/80 81/82 83/84 85/86 87/88 89/90 91/92 93/94 95/9650

Industry CEGB NP PG NE NGC

150

200

300

Productivity of CEGB and successor companies relative to UK manufacturing industry

Privatisation and restructuring

David Newbery Data from J Bower and C Humphries

6

0

5

10

15

20

25

30

35

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

£(20

01)/M

Wh

0

1000

2000

3000

4000

5000

6000

7000

HH

I

Electricity

coal cost

gas cost

Coal HHI

NETA

Price control Profit maximisingTacitCollusion

Restraint

plantwithdrawal

Real GB electricity prices and costs

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Unbundling transmission

• Unbundling T & G critical for competition– England unbundled and improved productivity– Scotland remained integrated -

• no productivity gain, little benefit from privatisation

– German utilities remain integrated• profits generated in network, deters and denies entry

• Vertical integration makes access regulation critical and very difficult

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Domestic electricity prices England and Scotland excl taxes

6

7

8

9

10

11

12

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

penc

e/kW

h (2

003

pric

es) Edinburgh

London

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Politically acceptable liberalisation requires:

• confidence in supply security• sustainable competitive outcomes• absence of market abuse• ability to mitigate market power• credible regulation for efficient free entry and

investment

These challenges remain in EU and elsewhere

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Competition policy for utilitiesPrinciple: separate out natural monopolies:

– “Competition where possible, regulate where not”=> Leave network services that are assured to be

workably competitive to competition law (?)=> Regulation essential for networks

But regulators should retain power to ensure that services are and remain workably competitive

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Dimensions of market power

• Short-term markets vs long-term contracts– elasticity of supply rises with more time

• Pools vs PX vs OTC markets– transparency may allow collusion

• Futures and forward markets– thin markets associated with market power– selling forward reduces spot market power

• Interconnectors and coupling– sequential markets offer more gaming chances

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Why is monitoring important?• Electricity has special characteristics

– supply and demand must be instantly balanced– cannot store in thermal systems– failures can cascade into blackouts– short-run demand elasticity very low– short-run supply may be inelastic at peak– cannot easily ration by price

=> system operation is a monopolyGenerators may have significant market power

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Why is monitoring important? 2

• Potential competitors need assurance that they will not be disadvantaged

• Power exchanges and OTC markets need liquidity for successful competition– like financial markets need careful monitoring to

detect and prevent fraud and manipulation• Market designs and grid codes, etc need

adjustment in light of experience– Monitor needs good information and analysis

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Contrasts between US and EUUnited States• Acquiring monopoly position may be illegal

– holding a monopoly is not, – fiduciary duty to maximise profits– contrast EU Art 82: abuse of dominance illegal

• ESI governed by Federal Power Act 1935– regulators must ensure prices are “just and reasonable”

EU• Directives limited to structure and networks

– treatment of G and S left to member states

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Implications for monitoringUnited States and PUCs• duty to monitor prices (“just and reasonable”)• duty to mitigate market power• strong tradition of publicly available dataEU• market monitoring needed to bring cases of abuse• monitoring to inform regulators of market behaviour

– critical in event of e.g. merger, change in market design

• need to be explicit about information powers– some regulators lack legal powers to demand information

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Importance of interconnectors

• Imports can compete with domestic G– can greatly reduce market power - Scandinavia

=> Maximise and efficiently allocate ATC• Loop flows require TSO cooperation• Cross-border ownership creates problems• Building interconnectors attactive

– both need NRA cooperation

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Congested interconnectors

Mainly congested indirection ofarrow

Congested bothdirections

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Percent of time contractualconstraintsexist in Benelux(Brattle, 2003)

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Data provided by UCTE

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44

4

12

40

1

22

23

23

15

3

100 MW CH-DE

Source: RTE

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Paul Twomey, Richard Green, Karsten Neuhoffand David Newbery

download CMI EP 71fromhttp://www.electricitypolicy.org.uk/pubs/wp.html

The Cambridge-MITInstitute

Part of the research was funded by the Association of European Transmission Operators ETSO.

A Review of the Monitoring of Market Power

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Market Power Detection Tools

Choose tools suitable for different tasks:

• Ex-ante versus ex-post analysis• Long-term vs. short-term/real time analysis• System-level market power vs. local market power

vs firm-level market power• Horizontal market power vs vertical market power

24

Applications of Market Power Detection Tools

Ex-Ante Ex-Post

Long-Term

- Merger rulings- Assessing applications for market-based rates - Determining potential must-run generators- requiring contracts

- Litigation cases (e.g. California refund case)- Changing market design- requiring contracts and VPPs

Short-Term

- Spot market bid mitigation- Must-run activation & other system operator contracting

- Short term price re-calculations- Penalties for withholding

Inspired by a similar table in Helman (2004)

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Market Power Detection Tools – List• Behavioral Indices and Analysis

– Bid-Cost Margins (e.g. Lerner Index)– Net Revenue Benchmark Analysis

• Structural Indices and Analysis– Concentration ratios and HHI– Residual Supply Index– Residual Demand Analysis

• Simulation Models– Competitive Benchmark Analysis– Oligopoly Models

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Bid-Cost Margins

• Lerner Index:

• In a competitive market LI is zero – if MC correctly interpreted as scarcity price

• Cournot oligopoly LI = market share/elasticity• Do not require geographic market definitions• Is a standard measure of exercise of market power• but which MC? Short-run or long-run?

PriceCost MarginalPrice −

=LI

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Residual Supply Index

• Measures the extent to which a generator’s capacity is necessary to supply demand after taking into account other generators’ capacity

• Residual Supply Index – continuous variable

Sheffrin’s screen test: RSI must not be less than 110% for more than 5% of hours per year

Demand TotalCapacityRelevent si'Company Capacity Total −

=RSI

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California RSI duration curve June-Sep 2000-2002 all hours

Sheffrin (2002)

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Significant Correlation between RSI and Price-Cost Markup

Sheffrin (2002)

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0%

25%

50%

75%

100%

125%

150%

Austria

Belgium

France

German

y

Italy

Netherl

ands

Switzerl

and

Spain

Gen 1Gen 2Gen 3FringeImports

Source: Remaining capacity and availability factor from UCTE Power Balance Forecasts 2002-2004, NTC from ETSO (Winter 2001/2002), National Generation Shares from ICF consulting, Annual reports and presentations

Generation companies have MP within countries... and retain market power due to transmission constraintscapacitydemand

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Residual Supply Index

• Takes account of capacity scarcity• Suited to dynamic analysis on an hour-by-

hour basis and local market power analysis• Empirical support of predicting market power• Needs access to availability data (from TSO?)

Arguably the best tool

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Collective dominance if:

• Market characteristics conducive to tacit coordination, and

• Tacit coordination sustainable:– firms lack ability and incentive to deviate, given

incentives for retaliation, and– Buyers, fringe firms, entrants cannot challenge

tacit coordination

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0

10

20

30

40

50

60

70

Apr-90 Apr-91 Apr-92 Apr-93 Apr-94 Apr-95 Apr-96 Apr-97 Apr-98 Apr-99 Apr-00

£/MWh (Jan 2000 prices)

PG gaming

Ofgem price review

Schedulingproblems

Nuclear outagesreduce plantmargin

Price falls tomeet price cap

Annual pricecap agreedfor 2 years

French strike& stationfailure

Plant divestmentto Eastern

Low availability &Eastern biddingstrategy

NP & PGmanipulation

SMPmanipulation

Capacitywithdrawal

Furtherplantdivestment

Pool prices since vesting

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Capacity Ownership of Coal Generation 1990-2004

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000A

pr-9

0

Oct

-90

Apr

-91

Oct

-91

Apr

-92

Oct

-92

Apr

-93

Oct

-93

Apr

-94

Oct

-94

Apr

-95

Oct

-95

Apr

-96

Oct

-96

Apr

-97

Oct

-97

Apr

-98

Oct

-98

Apr

-99

Oct

-99

Apr

-00

Oct

-00

Apr

-01

Oct

-01

Apr

-02

Oct

-02

Apr

-03

Oct

-03

Apr

-04

Oct

-04

MW

ALCAN

Innogy

National Power

British Energy

Independent

AES

Intnl Power

Edf

TXU/Eastern

Powergen

SS&E

AEP

Edison

Offer encourages sale of 6,000 MW NETA live

PG & NP trade horizontal for vertical integration

Source: NGC Seven Year Statements, various years, and data from J Bower and C Humphries, slide from D Newbery

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Collective dominance: the GB Electricity Pool

• Markets concentrated, transparent, mature • Low elasticity of demand • homogenous product, similar costs, shares • little excess capacity, barriers to entry ?• excess pricing, profit

– little response to cost fall, – barriers to switching ??

Need to be able to test for tacit collusion

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Residual Demand Analysis

• Best response to generator’s residual demand• Theoretical justification – Supply Function

Equilibria (locally profit maximising)• Requires individual bid data to construct

residual demand curves• Can detect collusion as well as market power• e.g. Wolak, Sweeting, Hortacsu/Puller

D Newbery Athens 37Hortacsu and Puller (2003)

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0

5

10

15

20

25

30

35

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

£(20

01)/M

Wh

0

1000

2000

3000

4000

5000

6000

7000

HH

I

Electricity

coal cost

gas cost

Coal HHI

NETA

Price control Profit maximisingTacitCollusion

Restraint

plantwithdrawal

Real GB electricity prices and costsSweeting’s periods

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Net Revenue Benchmark Analysis

• Compares estimated revenues with total costs• Assess financial viability and barriers to entry

– important in presence of price caps• Spark and dark spreads useful proxy

– need to allow for EUA opportunity cost• Persistent excess profit suggestive of market

power and barriers to entry• Persistent failure to cover total costs suggestive

of predatory behaviour?

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Spark spread month ahead 50% efficiency

-5

0

5

10

15

20

25

30

35

1-Se

p-02

1-D

ec-0

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2-M

ar-0

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1-Ju

n-03

31-A

ug-0

3

30-N

ov-0

3

29-F

eb-0

4

30-M

ay-0

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29-A

ug-0

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28-N

ov-0

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eb-0

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29-M

ay-0

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28-A

ug-0

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Eur

os/M

Wh

NLDEUKEUA cost

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Spark spread month ahead 50% efficiency

-5

0

5

10

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25

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35

1-Se

p-02

1-D

ec-0

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2-M

ar-0

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n-03

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ug-0

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ov-0

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ay-0

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ay-0

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Eur

os/M

Wh

NLDEUKEUA cost

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Spark spread net of EUA

-5

0

5

10

15

20

25

1-Ju

n-02

31-A

ug-0

2

30-N

ov-0

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ar-0

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ay-0

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ug-0

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ov-0

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eb-0

5

28-M

ay-0

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27-A

ug-0

5

Eur

os/M

Wh

UKDENL

EUA starts

Institutional and data issues

download CMI EP 71fromhttp://www.electricitypolicy.org.uk/pubs/wp.html

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Powers of Market Monitoring Units

• Generally monitor reports to regulator rather than taking action itself

• Primary task is to produce reports and conduct investigations– ideally these should be published on the NRA website

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Challenges of market monitoring

• Requires rapid access to relevant data– needs legal right and systems in place– some countries fail to provide this to regulators

• demands skilled analysis and data manipulation– challenging for new NRAs concerned with network

regulation and price controls

• may be outsourced– to academics (as in Netherlands initially)– to specialised consultancy

but need to have in-house expertise to interpret

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Where is the data?• TSO/ISO

– Physical flow patterns– Bids in balancing markets– Bids in pool (if run by TSO/ISO)

• Transmission Rights Auction (if independent of TSO/ISO)– Bids, market clearing prices and allocation of transmission rights

• Power Exchanges– Bids, market clearing price and allocation for spot market and

forward contracts of transactions through the power exchange.• Brokers, market makers

– Information on bilateral contracts brokered• Market participants

– Information on directly negotiated bilateral contract• Generators

– Information on costs, deratings, outages and capacities.

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Role of different players• Regulator has prime responsibility for MM

– issues guidelines, reports– working in close cooperation with TSO, PX and

explaining findings to stakeholders

• PX, MO need own monitoring– to assure traders, improve service

• Academics/media/consumers use published data for impartial comment

• Competition authorities need MOU with NRA– guidelines on how disputes investigated, resolved

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Data Issues• TSO/ISO requires physical data - well placed for

complete, central record– Hold data for > 2+ years to allow ex-post investigations

• Homogenous format for data reduces cost of analysis and increase the integrity of data

• Regulatory authorities should have access to data automatically or on request without legal proceedings

• Maximise public availability of data– no case for confidentiality for monopoly functions– otherwise aggregate/anonymize data – dangerous to restrict to electricity companies

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From Detection to Mitigation

• Standard Solutions:– Structural

e.g. divestiture, removing entry barriers, transmission expansion, demand responsiveness

– Regulatorye.g. vesting contracts, virtual power plant auctions,

sunshine regulation

– Market Rulese.g. unit-specific bid caps (e.g. AMPS)

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Concerns and problems• Companies will resist providing data

– particular problem if TSO is vertically integrated• Companies will dispute findings

– expect delays if process goes to court• Courts are poorly placed for economic analysis

=> avoid courts, appeals to competition authorities• Expect companies to hire consultants to dispute

– ensure that MM analysis well-found– hire/retain good academics to help

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Conclusions• Market power detection measures trade-off:

simplicity vs insight– better methods like RSI demand better data

• Powers to collect information critical– maximise publication for transparency and

market reassurance• Monitoring is demanding - outsource?• Cross-border cooperation between NRAs

important to facilitate efficient trade

The rationale for a market monitoring process

David NewberySoutheast Europe Electricity Market

Monitoring Workshop Athens 4-5 October 2005

http://www.electricitypolicy.org.uk

53

Acronyms - 1AMPs: Automatic Mitigation Procedure (very US)ATC: Available Transmission CapacityCEC: Commission of European CommunitiesCEGB: Central Electricity Generation BoardESI: Electricity supply industryEUA: EU allowance (permit to trade 1 tonne CO2)FERC: Federal Energy Regulatory CommissionGW: Gigawatt = 1000 Megawatt = 1m kWG: GenerationHHI: Herfindahl Hirschman IndexISO: Independent System OperatorMC: marginal costMO: market operator

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Acronyms - 2MOU: memorandum of undestandingMM: Market monitoringMP: Market powerNETA: New Electricity trading ArrangementsNRA: National Regulatory AuthorityOTC; Over the counter (markets)PUC: Public Utility CommissionPX: Power exchangeS: Supply

SSNIP: ‘small but significant non-transitory increase in price’RSI: Residual Supply IndexT: TransmissionTSO: Transmission System Operator