Price Spikes and the Problem of Market Power

Wholesale electricity prices tend to be more volatile than prices for other commodities, sometimes spiking sharply for hours, days or even weeks at a time. Price may still be equal to industry marginal cost during these spikes. In other words, price spikes in the wholesale market may simply be an efficient reflection of high demand (or the loss of supply from inexpensive units due to malfunction or routine maintenance) requiring that high-marginal-cost units come into operation. As suggested in the preceding section, price fluctuations can play an important role in covering the costs of rarely used capacity. However, we will see in this section that there may also be situations where competition is insufficient, market price deviates from marginal cost and price spikes are not efficient.

There are several reasons why wholesale prices can be volatile. First, electricity generally cannot be stored, so there are no inventories as in other markets. Second, demand is not very responsive to changes in price (in more technical terms, demand is “price inelastic”) on an hour-by-hour or day-by-day basis. This is because most consumers cannot see, and therefore cannot respond to, hourly price fluctuations.[10] Even if consumers could see wholesale market price fluctuations, price elasticity would still be fairly low. Once a consumer has purchased a TV or refrigerator, the price of power at any given hour will have to fluctuate significantly in order to influence consumer decisions about usage across the day or week. Third, supply can also be inelastic in the short run when capacity is tight. As a result, changes in conditions, including transmission constraints and hydro levels, can lead to large swings in market price. For example, if the transmission link between the North and South Islands temporarily loses capacity, North Island consumers are suddenly faced with reduced generation capacity and North Island generators are called upon to run expensive generating capacity that is seldom used. The industry’s marginal cost of meeting demand becomes very high and the price jumps.

When competition is weak, price spikes may not be benign. International experience shows that individual generators are sometimes able to manipulate the market price and exacerbate price spikes by withholding capacity and driving prices above marginal cost.[11] This happens when an individual generator finds itself facing little competition and is temporarily able to act as a monopoly, that is, able to exercise “market power”. These conditions tend to arise when prices are already spiking – such as in the transmission constraint example, above. International experience indicates that market power may appear, in an unpredictable fashion, for minutes or hours at a time. However, it is important to stress that we do not have clear empirical evidence on whether generators in New Zealand actually exercise market power or earn monopoly profits. Episodes of market power are very difficult to identify empirically.

What does this market power mean for our analysis of the price-bid margin introduced in the previous sections? Recall the incentives faced by the hypothetical firm Gen A when deciding how to bid each unit of its plant’s capacity. In its competition with other firms, Gen A realises it is in its own interest to bid each unit of capacity according to the true marginal cost. But, to paint the picture in stark terms, imagine Gen A suddenly faces no competition for a day – that is, it knows that it will be called on to satisfy all demand for electricity from a particular city or region. In this situation, Gen A has the ability to unilaterally drive up the price and earn large price-bid margins on the units that it produces. To highlight the difference from the competitive market situation described in the previous section, we can refer to these extra profits achieved by market power as “monopoly profits”. While the economic profits that may be earned in a highly competitive market play an important role in stimulating efficiency and ultimately benefit consumers, the monopoly profits earned in uncompetitive episodes hurt consumers with high prices and scarce supply.

Electricity markets can be susceptible to market power because of the unusual characteristics described above (no inventories, inelastic supply and demand, the need to maintain voltage and keep the electricity flowing) and also because entry by new generators tends to take a significant amount of time, particularly in countries with extensive permitting requirements. A number of features can help mitigate the scope for market power, including adequate transmission capacity, low barriers to entry of new generators, ample scope for hedging and demand-side responsiveness.[12]