1. Competition in generation or should it just be competition for new generating capacity?

Most electricity market reform has concentrated on creating competition in generation.  According to the WEC report, however, the successful introduction of competition in generation has seven preconditions:

(i) An attractive investment environment—as competition in generation always depends on having generating capacity which exceeds demand, attracting the investment to ensure excess capacity is maintained is a base requirement for the success of competition.  What constitutes an attractive environment for investors is outlined further below.

(ii) Excess generation capacity of between 20%–25%—sustained competition is always vulnerable to a generator not being able to operate for the bidding period concerned.  Ideally, therefore, excess system capacity should always be greater than the capacity of the largest generator.

(iii) Many competing generators—the exact number depends on the similarity of the competing generating plant. As price setting occurs throughout the full demand range, there needs to be competitors at every demand level.  The WEC report suggests that, for plants using the same fuel source and with similar cost structures (rarely the case in reality), five competitors may be sufficient and that, for dissimilar plant, no competitor should represent more than 10% of the total capacity.

(iv) High current prices in generation and supply—prices must be high at the commencement of the market.  If prices are not high, but are close to or even below production cost, the introduction of competition, which itself has a cost, is unlikely to be cost-beneficial.

(v) The will to lower electricity prices—if a country does not actually want to lower prices, because it has a need for steady or higher prices to pay off debt or add to capacity, there is little point in introducing competition. There are simpler ways, such as price regulation, of achieving the desired price profile.

(vi) Easy access to the grid—obviously, the difficulty of negotiating satisfactory conditions for transmission services must not present a barrier to new generation entrants.

(vii) A well connected or unconstrained grid—there must only be minor constraints in the transmission grid.  Transmission constraints will give rise to different competitive zones and generators that are sheltered by a transmission constraint will be able to extract higher prices.

According to the WEC report, remove even one item on this checklist, full competition in generation will not be possible, albeit certain competitive pressures may be introduced.

The report makes the observation that, if there is no excess generating capacity in a market, creating competition to construct new generating capacity may be a more important priority than trying to create competition amongst existing generators. Moreover, the introduction of competition in generation will actually compromise competition to construct new generating capacity because prices will be driven down and the market will be less attractive to investors.

As noted in these pages recently, a competitive electricity industry structure is not always more efficient than a vertical monopoly.   Everywhere, there are isolated or smaller power systems where a vertically integrated structure should remain as the preferred structure not only because of reliability, but also on efficiency grounds. That is, because the efficiency gains which arise from a competitive structure can actually be exceeded by the resulting transaction costs.

2. What leads to misuse of market power?

The WEC report does not directly address the issue of market power in electricity markets ,but it nonetheless prompts a serious question for policymakers.

A continuing challenge in electricity market regulation is how to identify instances of excessive conduct which overstep the mark.  There is nothing per se illegal about firms possessing market power or even monopoly power.
The traditional practice of competition regulators (in non-electricity markets) has been to prosecute firms which take advantage of, or misuse, their market power in order to dampen competition.  Firms are prosecuted if they have an evil intent, that is, if their demonstrable purpose is to damage competitors or deter them from competing in the market.

It is the essence of competition that competing firms should strive to outperform each other. Inevitably, the success of those that are more effective has injurious commercial consequences for those that are not so effective.

In traditional competition law, this is regarded as acceptable.  It is quite normal in non-electricity markets for competitors to jockey for sales with the result that the more effective competitors injure the less effective by taking their sales away.

In traditional competition law, it is only “excessive” competition which oversteps the mark.  The precise dividing line is, however, always difficult to find.

A number of questions should be raised about electricity markets.  If electricity markets are all about fostering competition, should a successful competitor which acquires market power be prevented from being even more successful?

Why shouldn’t a successful competitor be free to exploit its market power as vigorously as possible?  What is wrong with “strategic” pricing of electricity?  Why should free market behaviour be regulated?  After all, what is an electricity market for?

Electricity markets are nonetheless very different to commodity markets.  In electricity markets, price spikes regularly occur.  When this happens, by monitoring generator outage rates and changes in generator bidding patterns, regulators try to see if anything untoward has occurred.

Typically, however, they do nothing because they do not yet know the correct response to the challenge of electricity market regulation.  In uniquely volatile markets such as electricity, where the product cannot be stored and demand for the product is what economists call “inelastic”, it is apparent that traditional competition laws, with their focus on evil intent, are ill-suited to the challenge of market regulation.

3. What constitutes an attractive investment environment for power generation?

It is axiomatic that, the lower the rate of return, the greater the level of certainty that investors will seek and the lower the level of risk they will be prepared to accept. With the high debt levels that typify generating plant construction projects (around 70%), stability of industry policy, stability of the regulatory regime and a virtually uninterruptible ability to repay debt are crucial to investors and their bankers.

 The report makes the obvious point that the investment environment must be made sufficiently attractive to investors to ensure that sufficient generation capacity is commissioned to meet demand in a timely fashion.

The uncertainty which goes hand in hand with the introduction of competition in generation will often be unattractive to investors, particularly if there is excess capacity.  To some extent, this uncertainty can be reduced by a thorough trial of the proposed market.

As well, investors can still be attracted by the inducements of long-term power purchase agreements, risk hedging agreements and stranded cost arrangements.  Also, the availability of a cheaper source of fuel and a more efficient generation technology (as has happened with gas in several markets) will be relevant.

For a market to be attractive to investors, the WEC report suggests there should ideally be:

(i) clear demand for additional base-load capacity;

(ii) government and regulatory stability for at least two to three years and ideally five to 10 years;

(iii) efficient handling of tender applications, and the associated planning, environmental and connection applications;

(iv) market change subjected to constraints and clear arbitration;

(v) transparent, unbiased despatch rules;

(vi) clearly announced rules for any departure from economic merit order despatch; and

(vii) state ownership of no more than 20% of plant, as state enterprises need not operate to the same commercial imperatives as private investors and, in any case, have a lower cost of capital.

There can be no doubt, as the WEC report emphasises, that changes introduced by governments subsequent to the making of investment (for example, the UK’s windfall tax of 1997) undermine investor confidence.

4. Dealing with stranded costs

Prior investments or commitments, which could be recovered under pre-reform conditions, may not be recoverable following market reform. Fair arrangements to deal with such “stranded costs” are called for but such arrangements will always distort competition to some extent.

The WEC report suggests it is easier to deal with the stranded costs of government-owned entities than it is in the case of privately owned companies. In the case of the latter, successful negotiation of a solution calls for agreement on:

(i) market forecast assumptions;

(ii) electricity and fuel prices;

(iii) the cost recovery package (which may include the selling off of some assets); and

(iv) the future direction of market reform, if any.

Either way, a levy applied to the price of electricity to recover stranded costs will be better accepted where the advent of competition leads to a fall in prices greater than the levy (as happened in the UK, but not in California).

5. Sale of state-owned assets

Where market reform involves the selling of state-owned assets, there is always an important public interest in maximising the proceeds of sale.  As in the case of attracting investment in new generating plant, however, sale values will be compromised by the prospect of competition in generation being introduced.

In some early Australian privatisations (for example, in Victoria), high prices were paid for generating plants before the extent to which subsequent competition in generation would depress plant revenue was appreciated.  Investors nowadays are much more wary.

The WEC report has no inhibition in pointing out that some governments have down-played plans to introduce competition in generation until state-owned assets have been sold, thus maximising values, and have then introduced a competitive electricity market to lower prices for the electorate.

The report points out other government strategies by which asset values have been boosted, such as by understating plant operating costs, by inserting renegotiation provisions in power purchase agreements and by using state-owned plant to lower prices.

There is obviously a need for the utmost candour by governments about all contemplated structural and regulatory reforms at the time of sale of state-owned assets.

6. National and social goals

The report acknowledges the need, in designing electricity markets, to also take into account the proper balance between government, regulator and industry, the existence of any national energy strategy and the need for solutions to certain social issues:

(i) Balanced regulatory powers—the greater the unilateral power of the regulator, the greater also the investor’s risk, although a trend to tighter regulation, or re-regulation, is observed in the WEC report. The investor’s prime requirement is stability, which can be compatible with tight regulation, but investors also seek some influence over regulatory changes.  There is a need for a proper balance.

(ii) National energy strategy—according to the report, countries need to secure a suitable energy mix over timeframes of 20 to 30 years. An energy policy at variance with short-term market outcomes for some reason (for example, fuel security, environment, employment or dealing with stranded investment) is incompatible with full competition.

(iii) Subsidies and other social impacts—the report also emphasises the need to take account of social impacts.  In addition to the concern about customers who may not be able to afford service under market conditions, there can be other social impacts, such as the loss of competitiveness of an indigenous fuel industry (typically coal displaced by gas) or unemployment caused by increased power system automation. Market modifying measures may be needed to reduce these social impacts.

7. Models for competition in generation

Five actual or hypothetical models for competition in generation were identified in the WEC report:

(i) Pool with system marginal price—this model, with variations, was the first to be used in electricity market reform (in England and Wales followed Victoria). Generators and some or all wholesale suppliers bid into the pool.  A capacity element can be included.

(ii) Pool with pay-as-bid price—this is similar to most “outcry” commodity markets but has not actually been used. Generators would be paid as they bid, encouraging them to compete to set prices through the price curve.

(iii) Bilateral contracts with despatch priority and system balancing—this model became popular in the late 1990s and has now been adopted in England and Wales. Competition is more aggressive than in mandatory pools as a physical contract must be won in order for plant to be despatched. Various approaches are possible to avoid complexity in the balancing market.

(iv) Minimalist model—in this model, customer choice is introduced (as in Germany) through primary legislation, without any central settlement system being developed. This is effective in a well connected market with a large number of generators.

(v) Simple central market—in this model, the market is operated by a (preferably independent) system operator who verifies input costs and contract terms.

The two main models now in use to create competition in generation are (i) and (iii) above, namely a mandatory pool for all electricity generated and a contracts market with a balancing pool.

A trend towards contracts markets is clearly discernible. According to the report, although the two models vary in detail among countries, it is more their introduction into very different circumstances and industry structures that explains the varying outcomes.

8. De-linking despatch and price setting

Under either of the two main market models, the report recommends that despatch and price setting should be considered independently. The purpose of despatch is to meet demand within the set stability and frequency parameters, taking into account transmission constraints. The information needed is plant availability, the technical parameters of plant and transmission system, and costs to determine a basic merit order and non-merit order requirements.

The report suggests that, although despatch clearly needs to be done in real time, the information required for despatch does not change frequently and relatively simple information systems can be used. Even where costs tend to be quite stable, price volatility is more often due to market opportunities than it is to changes in underlying costs.

9. Reducing the frequency of price setting

The report emphasises that frequent price setting adds greatly to complexity, especially in terms of the information systems needed and new metering. It suggests that the system of representing the UK electricity market is more complex than the London Stock Exchange trading and settlement system.

Unless there are commensurate benefits, the WEC report finds that the cost of frequent price setting cannot be justified. Typically only some 5% of customers can respond to short-term price signals. The report recommends that special arrangements be made for this 5% without burdening the whole market with the complexity of real time or short interval pricing.

The report also claims that longer bidding periods add to the competitive pressure on generators. If the bidding period is a season or year, the risk is high and the incentive to bid prices close to costs is also high. On the other hand, with half hour or daily bids, a generator can always hope to operate in the near future.

Longer time-frames may also allow existing metering to be used. For all these reasons, the WEC report claims there is great value in using the longest pricing period that reflects underlying changes in costs, such as seasonal periods.

10. Conclusions

The WEC report broadens and deepens the debate over the pros and cons of electricity markets.  In particular, it highlights the unnecessarily high costs of introduction of complex market models, notwithstanding the gains in terms of cost efficiency, downward pressure on prices and more focus on customers.

It recommends de-linking despatch and price setting.  The report also prompts a serious question about how market power is to be regulated in electricity markets, an issue which I am sure will continue to absorb the attention of reformers and policymakers for some time.

It urges rigorous cost-benefit analysis of intended market measures to ensure that the desired benefits are commensurate with costs.  The report recommends using the simplest approach that will achieve the desired benefits to a reasonable degree. Its essential message is that it is all too easy for there to be a mismatch between market reform objectives and market models and that electricity market design must be kept as simple as possible!

Footnote: Mr Pritchard will speak on the theme “Overcoming the Institutional Obstacles to Energy Demand and Supply Imbalance” at the AIE conference in Sydney on November 21 and 22.
 
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