Einar HopeNorwegian School of Economics and Business

AdministrationETH Zürich 03.04.08

Overview

Some lessons from the Nordic, European and US power market reforms

Special characteristics of electricity in market termsMarket design of organised power marketsSome competition issues:

Potential sources of potential market powerMarket design of retail markets and some retail

competition issues

Regulation of network infrastructure. Some regulatory issues

Some characteristics of electricity as a commodity

Multi-dimensional product: energy(kWh), capacity(kW), voltage, frequency, security of supply, location etc).

Demand elasticity: price, income (short run - long run)

Derived demand. Low energy cost in relation to total cost

Seasonal variations: year, day. Load curvesCapacity adjustments. Hydro, thermalLong term investments. Generation, networkSelf service system

Characteristics of electricity markets

Electricity cannot be stored (hydro), homogeneous commodity

Instantaneous balancing of supply and demand by system operator

Very low short run elasticity of demand; also long run; derived demand; price signals with a lag, limited real-time pricing. Also low short run supply elasticity

Capital intensive, lumpy, irreversible and durable investment; fixed cost, sunk cost. Long lead times

Capacity constraints in transmission; the network as a ”market”

Market power issues deriving from characteristics and properties of electricity

Cost Curve

Price

Plant 1 2 3 4

C 1

P

q

P c

Rent

Figure : Industry cost (supply) curve. The rent concept

Demand

Hydro

Nuclear

Oil

Gas

Gas-turbine

q

Unit variablecost

Figure : Industry cost curve for energy. Merit order system

Q_

Q

D low

D high

MC

Q low

Figure : Marginal cost in a hydro power system

Welfare analysis – economic efficiency

Economic efficiency conceptsStatic efficiency

Technical efficiency. Productive efficiency Allocative efficiency X-efficiency (inefficiency)

Dynamic efficiency Technological change Product innovation, etc

Rent seeking

Decomposition of efficiency concepts.

Performance criteria: Efficiency dimensions

Static efficiency (operation)Cost efficiencyOptimal use of total production and grid capacity

Dynamic efficiency (investment/innovation)Optimal dimensioning of production and grid

capacityIntroduction of new technology and products in the

value chain (incentives for innovation)Facilitating market integration; spacially, across

energies, and in relation to other products/sectorsCapacity enhancing investment versus investment

in flexibility

Security of supply; reliability

Figure . Decomposition of efficiency concepts

Economic efficiency and market failure

Sources of market failurePublic goodsExternal effects in production and consumptionMarket imperfections

Economies of scale (natural monopoly) Monopolisation Lacking markets Competition monopoly regulations

Imperfect information; asymmetric informationUncertainty

Market failure in energy markets

Some lessons from the reform of the electricity industry

The Energy Act of 1990 in Norway: Establishing electricity markets, common carriage, vertical separation, regulatory system

A common Norwegian-Swedish market from 1996. An integrated Nordic market from 2001

Considerable gains from deregulation - still a considerable potential, especially in the grid and from further integration of energy markets

Reduction in the general price level of electricity - greater volatility of prices

(Cont)Greater flexibility on the demand side and change of

consumer behaviour: New contract forms, price competition, change of supplier, price information systems, risk hedging facilities, customer focus

Entry of new players in the markets: Brokers, traders, clearing companies, retail chains, petroleum companies, financial analysts, international energy companies

New organisational forms: Co-operative and outsourcing arrangements, e.g for power purchasing, invoicing, metering etc. Concern model, horizontal and vertical integration to end-consumers, separation and unbundling of competitive and monopoly functions

(Cont)

Ownership structure - cross-ownership, privatisationLong gestation period for competition in retailingInertia and opposition to change from suppliers:

Ownership structure, production orientation, market power, political influence. Consumer inertia/local loyalties, inexperienced consumers operating in new markets

Primitive risk hedging facilities and contracts for small consumers (households) - but developing

Regulatory lag - regulatory uncertainties

Design of organized power markets

Organized power markets operated by NordPool:Elspot (physical spot market deliveries)Eltermin (futures and forward contracts)Elbas (thermal power adjustment markets) Eloptions (European and Asian power options)Design and operation of “green” electricity

marketsMarkets operated by grid operators:

Regulation Market (Norway/Statnett): capacity market; balance market between real and planned exchange in the delivery phase on short notice (15 min)

cont

Elspot: daily trading for delivery next day for each of 24 hours. Price and quantity by noon - market contracts by 2.30 p.m., based on equilibrium price of aggregate supply and demand schedules (system price)

Eltermin: Futures market for hedging of power contracts up to three years ahead. Daily market settlement of the difference between system spot price and contract price. For forward contracts settlement only in the delivery week - no daily settlement

cont

Elbas: market for adjusting imbalances for thermal producers in Finland and Sweden after completing their Elspot trade. Continuous trading for single hours up to two hours prior to delivery

Clearing functions: Power Clearing System and Nordic Electricity Clearing (NEC operated by NordPool) of spot and futures contracts. Clearing also of bilateral contracts as of 1998.

Some 280 customers trading at NordPool (power producers, distributors, industrial companies, large retail customers, brokers, traders etc.)

cont

NordPool is a non-mandatory pool: around 70 % of total traded volume through organized markets; liquidity and efficiency?

On the whole: a successful market reform: considerable efficiency gains, integration effects and greater flexibility for consumers

Figure 1. Spot and consumer prices,

Nøre/kWh fixed 2002 prices

0,00

5,00

10,00

15,00

20,00

25,00

30,00

35,00

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Spot price Mining and manufacturing Other industries Households

Figure 3. Capa c it y, produc t ion a nd de ma nd. 1960-2004.TWh

0,0

20,0

40,0

60,0

80,0

100,0

120,0

140,0

160,0

1960 1965 1970 1975 1980 1985 1990 1995 2000

P roduc t ion De ma nd Ca pa c it y

Figure 4. Inve st me nt s in powe r supply a nd powe r

produc t ion. Mill 1960-2002. NOK - 2005 pric e s

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

20000

1960 1965 1970 1975 1980 1985 1990 1995 2000

P owe r supply P owe r produc t ion

Figure 6. Rate o f re turn in manufac turing and po wer pro ductio n. P ercent. 1963-2004

0 %

5 %

10 %

15 %

20 %

1963

1967

1971

1975

1979

1983

1987

1991

1995

1999

2003

Manufacturing Po wer p rod uct ion

F ig ure 7 . Inv e s tm e nts in ne two rk c a pa c ity. M ill N OK - 2 0 0 5 pric e s

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

1960 1965 1970 1975 1980 1985 1990 1995 2000

F ig ure 8 . P ric e s in dif fe re nt c o ntra c ts . S e rv ic e s . Øre / kWh

0,0

10,0

20,0

30,0

40,0

50,0

60,0

70,0

1998Q2 1999Q2 2000Q2 2001Q2 2002Q2 2003Q2 2004Q2 2005Q2

New f ixed pr ice Older f ixed pr ice

Spot pr ice Var iable pr ice

What went wrong in California?

Electricity industry before regulatory reform in April 1998:Three large investor-owned utilities (IOUs)Vertically integrated into generation, transmission

and distributionSignificant out-of region energy needed to serve in-

state demand. (Ca. 25%)Retail electricity rates regulated by California

Public Utilities Commission (CPUC)Wholesale prices and transmission tariffs regulated

by Federal Energy Regulatory Commission (FERC)

Factors contributing to ”crisis”

Small amount of new capacity built in California during 90’s, and also in surrounding states

Higher natural gas pricesForced outages since summer of 2000Price inelastic wholesale demandRetail price freezeFew consumers face real-time pricePrice cap on wholesale priceRegulatory differences between federal and

state (FERC and CPUC)

Competition issues: Market power

Definition of market power:The power to profitably raise the market price

above the competitive level

Observations on market power:Potential market power may or may not be

exercisedThe Lerner index (price – marginal cost/price) is a

measure of exercised market powerSeveral measurement problems

Potential sources of potential market powerDefinition of relevant market: Nordic,

national, regional, local. Organized markets and total market, including bilateral contracts. Importance of transmission capacity constraints.

Measuring market concentration: Vattenfall ca 50% market share of Swedish market; 20-25% of Nordic market. Many suppliers - low horizontal market concentration

Horizontal and vertical integration: strengthened market position, cross-subsidization, locking-in of customers, price discrimination

cont

Composition of energy system: hydro and thermal. Market power in hydro systems. Norway only hydro. Share of hydro power in the Nordic system: around 50%

Demand variations: daily and seasonal peak demand; summer-winter variations

Ownership and incentives: public ownership, cross-ownership, concentration

Capacity constraints in generation: underinvestment?

contCapacity constraints in transmission and

handling of constraintsAsymmetric information: large and small

players?Collusion: tacit or coordinated through

transparent markets?Entry conditions and behaviour: potential

competition as disciplining factorEnforcement of competition policy in

electricity markets and design of regulatory system for natural monopolies. Relationship between competition policy and sector-specific regulatory agencies

Market power in wholesale markets

As generation and load have to balance in real time, pivotal generators have very significant potential market power

Pivotal generators need not be big (in terms of annual production or market share)

But big generators are pivotal more often than small generators

Thus there is a positive relation between concentration and potential market power in wholesale electricity markets

Market power mitigation in wholesale markets

Splitting of major incumbents and reduced barriers to entry”More players in a given market”

Integration of previously separated local, regional or national markets”Larger market for a given set of players”. (Key

issue: interconnector/transmission capacity and pricing

Forward contracting”More markets for a given set of players”

Best practice, Nordic countries, Wholesale

Market integration and forward contracting: No significant exercise of market power documented

Features of the Nordic marketInterconnector/transmission capacity sufficient for

regional price equalisation most of the time (?)Degree of concentration relatively lowStringent market rules make relevant information

available for all market participantsSignificant share of hydro power

Some retail market developments

A very transparent marketAn increase in the number of suppliers

with “external” offers, i.e. outside their concessionary grid area

Restructuring of the retail trade market through mergers and acquisitions; increased regional concentration. Still a considerable number of players. New players entering the market (specialized traders, oil companies, electric appliance chains etc). Some problems with “unserious” entrants.

cont

Product innovations, mainly through new contracts

Price discrimination between small and large retail customers. Some suppliers now charge an “administration fee” for small customers to recover some of the switching cost and shift competition to large customers by giving special price offers

Somewhat reduced price spread over timeRetail markets are still national within the

Nordic market - no cross-border competition yet

Some retail competition issues

Sufficient mobility of retail customers (switching) to sustain effective competition?

Incentive for switching from reduced price spread?

Competition or coordination of prices of suppliers from transparency and frequent exchange of price information (market contact)?

Distribution of transaction costs between suppliers and end-users?

Increased vertical integration in the value chain. Implications for competition?

cont

Bundling of products from horizontal integration to other energy forms (gas and district heating), plus ICT products?

Risk hedging contracts - potential for improved contracts for households. Locking-in effects of risk contracts and long-term contracts?

Incentive effects of standardized load profile measurement and charging of customers?

Lowering of grid user prices through more efficient and stronger enforced regulatory regimes

Market power in Nordic retail markets

Low barriers to entry suggest that retail markets are ”contestable”

High actual and perceived switching costs may protect incumbents and give them market power

High retail market concentration in Sweden and Denmark

The process of benchmarking

Benchmarking: one of several possible methods or instruments for a regulator or a firm to assess the relative performance standard compared to a set of selected observations.

Steps in a benchmarking analysis:Identify the group of units (firms) for comparison;

demarcation of functionsIdentify range of potential methodologiesIdentify outcome equivalent to best practiceCollect data on a consistent basisConduct analysis. Compare own performance with

best practicePlan and implement improvements. Assess outcome

and implement corrective measuresExamples of benchmarking from SESSA

Investment in power markets; reference to the Nordic market

Experience mainly with the operation of a market based system within a given capacity. Will the market pass the optimal investment test?

Large excess capacity in the former system. Approaching/exceeding binding capacity constraints in production and transmission.

Different principles for the handling of capacity constraints among the Nordic countries. Need for harmonization.

Consider investments in the whole value chain; more focus on investment in the end-use part?

Types of regulation

Self regulationDirect regulationIncentive regulation

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Regulation and competitionRegulation of one-product production and full

informationRegulation of multi-product production and

asymmetric information

Regulation of natural monopoly

Defining natural monopolyDemarcation of functionsExtent of n.m.Organisation of n.m.Pricing of servicesOperation of system - dimensioning of

capacity (investments)Regulation of n.m.

Regulatory mechanisms (models)

Rate of return regulationMarginal cost regulationFull cost regulationPrice-cap regulationYardstick regulation (competition)Price discrimination

Network regulation in Norway

Rate of return regulation until 1997. Then revenue-cap regulation (income frame), but with elements of RoR and yardstick regulation

Co-ordinated annual data collection. ValidationDEA used to estimate efficiency frontier and calculate

individual efficiency factors190 distribution units, 30 regional grid units, pluss

StatnettReview of regulatory model and experience. New model

envisaged for 2007-12. Regulatory model in view of network reorganization, a

Nordic integrated electricity market, the network as an instrument for a market based system, harmonizing regulatory rules and principles, etc