Summary and Introduction

Over the past twenty years, many countries have introduced competition into their electricity industries, with the goal of greater efficiency and benefits to consumers. This has turned out to be a very complex, multi-dimensional undertaking and the “best practice” is still evolving. Economists around the world are still learning from the experience of electricity markets. In New Zealand, two recent events – against a background of spikes in wholesale electricity market prices (see Figure 2) – have fostered interest in electricity market competition. First, in late 2005, the Commerce Commission launched an investigation "due to complaints and concerns about electricity prices, company profits…and a perceived low level of competitive activity" (New Zealand Herald 2005). Second, the International Energy Agency’s (2006) review of New Zealand claimed “market power abuse is a real threat.”

This paper provides context for these developments by reviewing the international economic literature and building on the discussion of wholesale electricity markets in an earlier issue of the Policy Perspectives series (Came and Dupuy 2005). In order to keep the discussion focused, the main consideration here is competition and incentives in the wholesale market, in which generators compete to sell into the transmission grid.

The main points are:

• International experience shows that wholesale electricity markets may sometimes be susceptible to bouts of inadequate competition. In particular, transmission constraints can temporarily isolate geographic regions from the larger market, allowing local generators to exercise “market power” by withholding capacity and artificially boosting prices.
• It is very difficult to identify episodes of market power empirically: price spikes will occur even in competitive markets and are not necessarily evidence of market power. This paper summarises several empirical approaches and their strengths and weaknesses. There is little empirical evidence currently available for New Zealand.
• The international literature suggests that several factors can help promote competition in the wholesale market: robust transmission capacity, widespread forward contracting, demand-side responsiveness to price fluctuations, reduction of regulatory uncertainty and removal of barriers to entry for new generators. In addition, some economists recommend that every country should have an independent, forward looking “market monitor” institution charged with collecting data, providing analysis, and recommending policy changes regarding market power.
• However, market power mitigation should not be pursued at all costs. It is unlikely to be practical or feasible to eliminate all scope for market power. For example, additional transmission capacity can help promote competition, but this benefit should be balanced against the cost of construction and maintenance.
• In addition, it is important to avoid introducing new distortions to incentives for investment, for example by treating all price spikes as undesirable. The international literature suggests that, in some markets, prices do not spike high enough to support optimal investment. This is sometimes because of price caps and other distortionary policies. However, even in the absence of these policies, the short-run unresponsiveness of demand to prices can lead to inefficient signals for long-term investment.

None of these points argue for a fundamental revamping of New Zealand’s electricity policy or industry structure. Instead, it is important to focus on details to “get incentives right” for competition and investment.