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Electricity Generation: Competition, Market Power and Investment - PP 06/04

When Competition Is Weak: The Problem of Market Power

Why should policymakers be concerned about market power and lack of sufficient competition in wholesale electricity markets? After all, at least in textbook treatments, economists are often sanguine about the ability of individual firms to exercise market power in product markets: in the absence of barriers to entry, new firms are attracted to industries that exhibit excess profits, in the process “competing away” the profits.

Several unusual economic attributes can leave wholesale electricity markets susceptible to market power.

However, there is now a fairly strong consensus among economists who study electricity that there are unusual economic attributes that make wholesale electricity markets significantly different – and more susceptible to market power – than other product markets (see, among others, Borenstein and Bushnell (2000), Joskow (2002, 2003), Newbery (2002) and Wolak (2003b)). While it is possible to think of other product markets that share some of these characteristics, it is the combination of these characteristics that makes electricity so unusual from an economic point of view.

In particular, transmission networks are limited in the amount of power they can carry. The degree of network congestion varies depending on supply and demand conditions (which typically change over the course of the day, with spikes occurring, for example, when households switch on heat in the evening). Congestion can limit – intermittently and often for only short periods – the number of generators that can sell to a given demand location, giving some the ability to exercise market power while the period of congestion lasts. The other unusual economic characteristics of wholesale electricity markets can heighten the effect of this market power:

  • The very short run (that is, hourly or daily) responsiveness (or “elasticity”) of consumer demand to changes in price tends to be low. This is because most consumers do not have meters and thus cannot see fluctuations in hourly prices; even if they could, elasticity might still be fairly low – once a consumer has purchased a computer, refrigerator or expensive piece of manufacturing equipment, the price of power at any given hour would have to fluctuate significantly in order to influence decisions about usage across the day.
  • The short-run elasticity of supply to changes in price can also be very low, particularly when plants are operating near capacity.
  • Entry by new generators can be very slow. A new plant can take years to build, particularly in jurisdictions with extensive permit requirements.
  • Electricity cannot be stored. (Large-scale batteries are still too expensive to be worth considering from an economic point of view.[7]) As a result, aggregate supply and demand must equal one another on a moment-by-moment basis.[8]

Intermittent transmission constraints can temporarily cut off competition and allow individual generators to enjoy market power. 

For an example of the implications of this unusual combination of characteristics, consider a transmission constraint that temporarily frees a generator near a large population centre from the constraints of competition with other, more distant generators. Low demand elasticity means that the generator could withhold a fairly small amount of capacity – perhaps by suddenly deciding to take part of capacity down for maintenance – and be rewarded with a substantial temporary increase in market price (at least in the nearby population centre).[9] In this case, the high prices earned on the generator’s remaining “online” capacity more than compensate for the lost revenue on the relatively small amount of withheld capacity. In non-electricity product markets, even if producers are temporarily unable to transport goods from distant factories to consumers, inventories help dampen the price impact and limit the scope for market power.

Notes

  • [7]Newbery (2002) and others point out that water behind dams in hydro systems can be thought of as “stored” electricity. However, the salient point for the present discussion is that, regardless of the nature of the fuel inputs, inventories of the finished product (electricity) cannot be stored in any practical large-scale way. This is very different from other industries where inventories of output can be accumulated.
  • [8]More precisely, electricity supply, less losses, must equal demand. In practice, all transmission networks experience losses. Electricity is gradually lost as it travels along transmission lines so that less power is withdrawn (by consumers or distributors) from the grid than injected by generators.
  • [9]In wholesale electricity markets in New Zealand and most other countries, electricity prices can vary by location. The market is set up so that demand and supply are calculated separately at each node (a point where electricity can be injected or withdrawn from the grid).
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