What Should Be Done About Market Power?

Policymakers shouldn’t wait for bullet-proof evidence of a market power problem.  Instead, they should work consistently to promote competition.

As we saw in the previous section, there will always be debates about the size and costs of episodes of market power. At the very least, it can take considerable time after the fact for analysts to come to a reasonable degree of agreement about the empirics of an episode of market power in a particular wholesale market. For this reason, the international literature on the economics of electricity suggests that policymakers should think carefully about appropriate institutions to promote competition and mitigate the scope for market power – even if the measurement of market power is not conclusive. At the same time, it is important to remember that it is impossible to completely eliminate market power and efforts to ameliorate market power should be balanced against the costs of doing so (Twomey et al 2004). For example, society could spend additional money on expanding transmission capacity. However, there is a point where the cost of additional transmission capacity outweighs the benefit of the reduced congestion.

Special caution should be taken to avoid introducing any new distortions: market power mitigation should not be a witch hunt. Regulators are faced with the difficult task of identifying and mitigating market power without distorting incentives for investment. Another lesson is that legal anti-trust systems are not adequately forward-looking and should not be relied upon to deal with market power – although they can play an important part.

As mentioned in Came and Dupuy (2005), there are several broad features of market design that can help to mitigate market power:

Ample transmission capacity is essential: it forces distant generators to constantly compete.

Transmission capacity and transmission regulation: As noted above, transmission congestion can limit competition. For this reason, adequate transmission capacity is very important for well-functioning competitive wholesale markets.[13] In other words, a competitive electricity market requires a robust “economically reliable” network (Wolak 2003a).

Many countries have had trouble getting transmission regulation “right”. 

Transmission regulation is a complex subject and deserves an extended discussion that is beyond the scope of this paper. However it is worth noting several points. Almost all countries with restructured electricity industries have had particular trouble with transmission regulation and, in practice, incentive regulation has been difficult to “get right”. There are many lessons to be learned from the experience in England and Wales, where policymakers have evolved a relatively comprehensive regulatory framework for transmission.

Hedging and forward contracts: Having a significant fraction of electricity production committed in forward contracts significantly reduces the scope for market power. This is because firms that have pre-contracted at a certain price have less capacity with which to try to unilaterally influence spot market prices. Hedging can take several forms – there can be a formal hedge market with a range of pre-sized types of contracts. There can also be various bilateral agreements tailored to the particular situation that are not traded on a market. In addition, vertical integration – the existence of a generator and retailer together in one firm – can be thought of as a form of hedging (see Hunt 2002, for example). Hedge markets themselves can sometimes suffer from market power and policymakers concerned about wholesale market power should be on guard against distortions in hedging arrangements.

Demand side responsiveness: An increase in the elasticity of demand – that is, the degree to which consumers reduce their demand when the price increases in the wholesale market – will tend to reduce the severity of market power. A given generator may still be able to unilaterally increase prices by withholding capacity, but heightened demand elasticity will mean that the resulting price increase – and thus the payoff to the firm – will be small. If the potential payoff is small, so will be the incentive to exercise market power.

Low barriers to entry for new generators: The speed of entry of new generators in response to the incentive of excess profits in the wholesale market tends to be slow. Many countries have extensive permitting and public review processes. These often serve very useful purposes and have substantial benefits (eg, in terms of environmental protection), but it is important to keep a careful eye on the associated costs (such as distortion of generator investment decisions). Unfortunately, these opposing benefits and costs are difficult to quantify and are rarely comprehensively measured.

A regulatory body charged with monitoring market power: Several economists (Wolak 2004 and Twomey et al 2004) make the case that every wholesale electricity market needs a regulatory body charged with promoting competition and limiting the scope for market power. Broadly speaking, these authors share a view of the emerging “best practice” design for such a “market monitoring” agency:

• The market monitor should be “prospective” – that is, the major task should be to watch for the potential for market power. Identifying, measuring, documenting and responding to past episodes of market power can be important, but, because of the measurement problems described in the previous section, the market monitor should also be encouraged to look forward and monitor the ongoing state of competition.
• The market monitor should collect and regularly publish data on a consistent basis. This can act as “sunshine regulation” which can help restrict market power.
• As discussed in the previous section, the market monitor should use a range of approaches to measuring and identifying market power.
• The government should support these principles and allow the market monitor operational independence.
• The market monitor should have oversight concerning wholesale market rules and the capacity to make recommendations about system operator (SO) functions.[14]

Twomey et al caution that there is no clear single model. Wolak points to Australian success and says “market monitoring is a process of continuous improvement” (p. 19).