Experience you can trust.

Market Power and Market Monitoring

9th Baltic Electricity Market Mini-Forum

Dr. Konstantin Petrov

September 2009

2

Content

Competition

Market Power

Market Monitoring

Indicators to Measure Market Power

3

Competition

4

Fundamental Price Drivers

End-User

PricesDemand

• Peak load (MW)

• Load growth (MWh)

Competition

• No straight forward indicator

Supply

• Fuel prices

• Available generation

• Available transmission

•Network access

•Regulatory uncertainty

•Market design

•Taxes/Levies/surcharges

Regulation

Competition is only one of the factors influencing electricity prices!!!

5

Definition

Adam Smith: "in the sense of rivalry in a race, a race to get limited supplies or

a race to be rid of excess supplies".

Marshall: “The strict meaning of competition seems to be the racing of one

person against another, with special reference to bidding for the sale or

purchase of anything. […] In modern economic theory, a market is said to be

competitive, when the number of firms selling a homogeneous commodity is so

large, and each firm’s market share is so small, that no individual firm finds

itself able to influence appreciably the commodity price by varying the quantity

of output it sells“.

Oxford dictionary of economics: “the situation when anybody who wants to

buy or sell has a choice of possible suppliers or customers”.

6

Perfect Competition

Characteristics

Each firm sets its price at the level of its

marginal costs to maximise its profits

If a firm sets a price above the price of other

firms it sells nothing

If a firm sets a price below the other firms’, it

will have to supply all of the market demand

for the product

If a firm charges less than marginal costs, it

will fail to break even for that unit of output

Under perfect competition, marginal revenue

equals price and each firm is a price taker

Assumptions:

A vast number of buyers and sellers of the

same, homogeneous product

Perfect mobility of people and resources,

Profit-maximising behaviour by producers,

welfare-maximising behaviour by

consumers

Perfect knowledge by all buyers and

sellers of all relevant present and future

conditions in all markets

Absence of externalities

7

Perfectly Competitive vs. Real Markets

According to economic theory, prices in perfectly competitive markets should be

equivalent to marginal cost.

In practice, however, prices on power markets sometimes are considerably

higher…

Supply / sale

Demand /purchase

Volume (MW)

Price(€/MWh)

8

Workable Competition

Perfect competition is well-recognised as unrealistic in real life

The concept of workable competition emerged from literature (Clark,

1940):

– “a market where competition is not perfect but allows the different

buyers and sellers to choose between a sufficient number of

alternatives” or

– “workable competition can be defined as the persistent absence of

players with market power”

Basic criteria: limited number of suppliers, no large differences between

parties, limited barriers to entry, low switching costs

9

Market Power

10

Market Power / Definition

Definition: “Market power is the ability of a firm to profitably raise the price

of a product”

Market power exists in nearly every product market

Only perfectly competitive markets exhibit no market power; in all markets,

privately-owned firms continually attempt to exercise market power

Prof. Wolak:

– Question is not whether or not firms exercise market power

– Question is when does the exercise of market power cause significant

harm to consumers

11

Technical Characteristics of Electricity Business

Power flows follow the laws of physics

Transport of electricity is constrained (congestion)

Power generation is constrained (ramping rate, black start capabilities,

environmental factors)

Storage is extremely limited and expensive

Demand varies each second and need to be balanced instantaneously

12

Economic Characteristics of Electricity Business

Absolute cost advantages of established firms

– Techniques

– Know how

– Research

Consumer loyalty

Capital requirements and funding constraints

Economies of scales

Irreversible commitment

13

Typical Reasons for Market Power

Transmission constraints and market fragmentation

High degree of concentration

Inelastic demand

Peak demand conditions and instantaneous balancing

Strong national incumbents

Joint capital control of generation and transmission capacities

Gaps in market arrangements

14

Market Power Strategies - Capacity Withholding

Competitive case

Bids

Volumes

Price 1

Bids

Volumes

Price 1

Price 2

Capacity withholding

15

Market Power Strategies - Strategic Bidding

Competitive case Strategic bidding

Bids

Volumes

Price1

Bids

Volumes

Price 1

Price 2

16

Market Power Determinants

Physical - Generation & Load

– Cost, capacities (supply curve)

– Ownership structure of generation assets (market share)

– Price elasticity of demand

– Load profile

– Network constraints

Administrative & Regulatory Environment

– Type of market - mandatory/voluntary

– Existence of bilateral trading, forward contracts etc.

– Market entry regime, market monitoring

– Horizontal / vertical integration

17

Studies on Market Power

Newbery/Green (1992 and 1995) observed significant exercise of market

power in the old E&W Pool (complacent duopoly)

Frank Wolak estimated substantial welfare damage caused by the

exercise of market power in California in 2000/2001

European Commission (Sector Study 2007) concluded unsatisfactory level

of competition on EU market due to high concentration and constrained

transmission interconnection (market fragmentation)

Von Hirschhausen (2007) observed insufficient competition in the German

electricity market (mark-ups > 30 %)

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Market Power Examples

Daily base & peak load index APX July 2001

0

50

100

150

200

250

300

350

400

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31

Euro

/MW

h

Base load Peak load

Single Hour Average Price - Base

10.00

60.00

110.00

160.00

210.00

260.00

310.00

EU

R/M

Wh

APX, The Netherlands July 2001 EEX, Germany December 2001

The Dutch regulator and TSO expressed significant concerns in 2001

when huge spikes appeared at APX (up to 1200 €/MWh in single hour)

In Germany, large price spikes appeared at EEX in December 2001

19

2004

2005

31.0

7.20

0330

.09.

2003

30.1

1.20

0331

.01.

2004

31.0

3.20

0431

.05.

2004

31.0

7.20

0430

.09.

2004

30.1

1.20

0431

.01.

2005

31.0

3.20

0531

.05.

2005

31.0

7.20

0530

.09.

2005

30.1

1.20

05

100

90

80

70

60

50

40

30

20

10

0

€/M

Wh

21958 h

EEX gleitender Monatsdurchschnitt

Geschätzte Grenzkosten gleitender

Monatsdurchschnitt

Market Power Examples

Schwarz / Lang (2007) shows differences between estimated marginal

cost and EEX price in Germany

Source: Schwarz / Lang 2007

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Market Monitoring

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Objectives

Identify market design flaws or anti-competitive behaviour

Assist the different parties in identifying improvements in market

arrangements

Ensure corrective actions

Prevent from future problems

Close monitoring discourage rule violation

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Scope

Continuous analysis to identify potential problems requiring further study,

including design flaws and undesirable behaviour

Investigation of any problems identified by own screening, or in response

to complaints from others

Regular reporting on the results of analysis and investigations

Collect and publish other relevant market information

Take corrective actions, initiate / recommend rules changes and other

improvements

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Principles

Main principles

Outcome orientation

Customer focus

Proportionality (i.e. being aware of and limiting the regulatory burden) and cost efficiency

Additional principles

Consistency over time

Public reporting subject to any confidentiality requirements

Encourage market participants to collaborate with the monitoring activities

– Transparency allows other entities to perform their own analyses and contribute to

monitoring

Special investigations in response to specific market outcomes and/or events

Avoid regulatory micro-management interfering with normal market outcomes

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Types of Monitoring

Approved Market Rules

Compliance Monitoring Are players fulfilling their obligations?

Competition Monitoring Are players behaving competitively?

Day to day reporting

Timeliness and correct format of bids, notifications,

reporting rules etc.

Prices, volumes, constraints that became binding,

incidents

Analysis

Price trends, incidents, constraints, market structure etc.

Measures (discussions, warnings, sanctions)

Proposals for change

Market structure Market rules

Existing market participants

Qualitative and informal

monitoring

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Indicators to Measure Market Power

26

Competition Analysis

Study whether market power is exercised or exists

Types of analysis

– Structural Analysis

Concentration ratio (CR)

Market Share and Herfindahl-Hirschman Index (HHI)

Residual Supply Index (Pivotal Supplier Indicator)

– Behavioural Analysis

Price-Cost Margin Index (PCMI)

Lerner Index (LI)

– Simulation Models (competitive benchmark using oligopoly models)

27

Concentration Ratio (CR)

m

iim WCR

1

(%)

A commonly accepted measure of market concentration

Takes into account the market share of the firms

Measure the concentration of the one (CR1), three (CR3) or five largest companies (CR5)

For monitoring purposes thresholds indicating market power: CR1> 33,3%, CR3 > 50%, CR5

> 66,7 %

Does not assess the behaviour, market power may be exercised in markets with low

concentration

28

Herfindahl-Hirschman Index (HHI)

n

i

in WCR1

2 (%)10000

A commonly accepted measure of market concentration

Takes into account the market share of the firms

Approaches zero when a market consists of a large number of firms of relatively equal size

HHI increases both as the number of firms in the market decreases and as the disparity in size

between those firms increases

For monitoring purposes usually some indicative limits are used, e.g.: low concentration HHI <

1000, moderate concentration 1000 < HHI < 1800, high concentration HHI > 1800

Does not assess the behaviour, market power may be exercised in markets with low concentration

29

Characteristics of HHI

HHI for equal shares

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

1 2 3 4 5 6 7 8 9 10 11 12 13

Number of players

HH

I

Moderately concentratedHighly concentrated

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Characteristics of HHI

HHI for 1 dominant player

0200400600800

1000120014001600180020002200240026002800

0% 3% 6% 9% 12% 15% 18% 21% 24% 27% 30% 33%

Difference between the dominant player and the players with equal shares

HH

I

HHI with 6 players

HHI with 10 players

Moderately concentrated

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HHI in Romania

MIN (HHI) = 2.738MAX (HHI) = 3.914

20022002

20042004

1.4551.742

1.3421.400

1.3421.488 1.439

1.5571.490

2.738

2.764

2.803

2.944

2.848

2.005

2.105 1.809

3.012

3.025

3.043

3.364

3.226

3.708

3.261

3.279

3.604

3.914

0

500

1.000

1.500

2.000

2.500

3.000

3.500

4.000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27

MIN (HHI) = 1.342MAX (HHI) = 2.944

20032003

The Herfindahl-Hirschman Index calculates the sum of The Herfindahl-Hirschman Index calculates the sum of the squared market shares of all generators in the market the squared market shares of all generators in the market and it rangeand it range From 0From 0 for a perfectly competitive market for a perfectly competitive market 0 – 1.000 the market is reasonably competitive 0 – 1.000 the market is reasonably competitive 1.000 – 1.800 the market is moderately concentrated1.000 – 1.800 the market is moderately concentrated 1.800 – 10.000 the market is highly concentrated 1.800 – 10.000 the market is highly concentrated To 10.000To 10.000 for a monopoly. for a monopoly.

n

i

shareMarketHHI

1

2generator i of %

Source: OPCOM

32

Residual Supply Index

100

TD

CTCRSI i

A commonly accepted measure of market concentration

Measures the importance of each individual company to meet demand

If RSI higher than 100 %, the residual capacity is enough to cover demand

For monitoring purposes usually some indicative thresholds are used, e.g.

RSI should be not less than 110 % for more than 5 % of time (438 hours

per year)

33

Price Cost Margin Index and Lerner Index

100

MC

MCPPCMI 100

P

MCPLI

Commonly accepted measures of competitive behaviour

Takes into account the difference between actual market prices and

competitive market price measured by marginal cost

Significant deviations from competitive market prices indicate market

power

Difficulties with computation of marginal cost and interpretation of results

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Estimation of the mark-ups for the different demand segments

Simulation of strategic behaviour (Gaming)

Production Cost Curve (Estimate system marginal cost)

Build generation portfolios

Defining the Demand Segments

Simulation Models / Approach

35

Simulation Models / Techniques

Advantages

•Flexible•Tractable•Important existing literature

Cournot(Quantity)

•Little descriptive power•Not very realistic (pure quantity bids)•Weak predictive power

•Realistic (firms do not sell all their output to the spot market )•Impact on market power?

ForwardContracts

•Requires additional assumptions

•More realistic (reflects actual bidding rules)•Allow better understanding of companies’ bidding behaviours• Better predictions

SFE (Supply Function

Equilibrium) (Quantity+price)

•Little computational tractability •Multiple equilibrium

•Flexible•Tractable•“non-storability“ aspects

Bertrand(Price)

•Not very realistic (pure price bids)•Producers have limited capacity•Weak predictive power

Disadvantages

Kahn (1998), Andersson and Bergman (1995), Hogan (1997) Borenstein and Bushnell (1999), Smeers and Wei (1999), Hobbs et al. (2002, 2003), Younes and Ilic (1997), Berry et al. (1998), Stoft (1999), Willems (2002)

Hobbs (1986), Aghion and Bolton (1987)

Klemperer and Meyer (1989), Green and Newbery (1992), Bolle (1992), Bohn et al. (1999), Rudkevich et al. (1999), Day et al. (2001), Baldick and Hogan (2001)

Allaz and Vila (1993), Bolle (1993), Powell (1993),Batstone (2000), Newbery (1998) , Green (1999)

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KEMA Market Models

Overview

PLEXOS, ProSym, SYMBAD

Short-term

dispatch and

strategic bidding

SDDP

Water optimisation

PSS/E, PowerFactory, ELEKTRA

Network Models

(Load flow

analysis)

KREMLIN

Balancing market

KEEM, PLEXOS

Long-term

planning

37

Practical Issues

Structural indicators possess low predictability power, market power can exist in

market with low concentration

Estimation of marginal cost may be arbitrary:

– Large data volumes needed, low data granularity and data gaps

– Consideration of start-up cost

– CO2 emissions

– Mathematical algorithms

It is arbitrary whether (short-term) marginal cost and perfect competition models

should be used to set competitive prices

Definition of competitive prices using oligopolistic competition requires different

type of modelling and depends on series of assumptions

38

Conclusions

Market power is a major threat on electricity markets

The major question is not whether some companies have market power, the

question is whether they abuse it!

Monitoring is necessary to:

– Identify market design flaws or anti-competitive behaviour

– Ensure corrective actions

– Prevent from future problems

There are several good structural indicators (CR, RSI, HHI), however with low

predictability power

Behavioural indicators (LI, PCMI) describe better market performance, however

difficulties in the computation and interpretation process

Experience you can trust.

Many thanks!

KEMA Consulting GmbH

Kurt-Schumacher-Str. 8, 53113 Bonn

Tel. +49 (228) 44 690 00Fax +49 (228) 44 690 99

Dr. Konstantin Petrov

Managing Consultant

Mobil +49 173 515 1946 E-mail: konstantin.petrov@kema.com