Market power issues in the reformed Russian electricity supply industry

Transcription

1 Market power ssues n the reformed Russan electrcty supply ndustry EPRG Workng Paper 1333 Cambrdge Workng Paper n Economcs 1358 Nada Chernenko EPRG WORKING PAPER Abstract.Keywords JEL Classfcaton The paper examnes long-run and short-run levels of market power n the lberalsed Russan electrcty market. We observe that despte potental for market power abuse, actual exercse of market power as measured by prce-cost markups remaned low. We attrbute the result to the bd-at-cost rule mplemented as a part of a specal unt commtment procedure on the day-ahead market. We frst look at the restructured ndustry and dscuss the mergers and acqustons and ther mpact on competton n long term. The M&A were undertaken n dfferent market zones and thus dd not seem to ncrease concentraton (HHI remans almost unchanged) although wth future zone ntegraton competton n long run s put at rsk. We then examne short-run level of market power by estmatng hourly prce-cost mark-ups and assessng ther dynamcs n 2010 and 2011, a year preceedng and followng the market lberalsaton respectvely. Usng tme seres models (AR models) we reject hypothess of actual market power abuse. Further, usng a Tobt regresson we fnd that the lberalsaton decreased the mark-ups by about 1.66 percetage ponts.. Russan electrcty market, lberalsaton, market power, concentraton, prce-cost mark-ups L11, L13, L94 Contact nc346@cam.ac.uk Publcaton June 2013 Fnancal Support Trnty College Eastern European Research Bursary

2 EPRG 1333 Market power ssues n the reformed Russan electrcty supply ndustry Nada Chernenko October 2013 Abstract. The paper examnes long-run and short-run levels of market power n the lberalsed Russan electrcty market. We observe that despte potental for market power abuse, actual exercse of market power as measured by prce-cost mark-ups remaned low. We attrbute the result to the bd-at-cost rule mplemented as a part of a specal unt commtment procedure on the day-ahead market. We frst look at the restructured ndustry and dscuss the mergers and acqustons and ther mpact on competton n long term. The M&A were undertaken n dfferent market zones and thus dd not seem to ncrease concentraton (HHI remans almost unchanged) although wth future zone ntegraton competton n long run s put at rsk. We then examne short-run level of market power by estmatng hourly prce-cost mark-ups and assessng ther dynamcs n 2010 and 2011, a year precedng and followng the market lberalsaton respectvely. Usng tme seres models (AR models) we reject hypothess of actual market power abuse. Further, usng a Tobt regresson we fnd that the lberalsaton decreased the mark-ups by about 1.66 percentage ponts. 1. Introducton In many electrcty markets around the world, restructurng and lberalsaton led to hgher market power (as measured by the prce-cost mark-up). 1 By contrast, we argue that n Russa a smlar electrcty market reform conducted n dd not translate nto hgher prcecost mark-ups. Ths s especally surprsng gven a merger wave that followed soon after the ndustry restructurng and hstorcally low volumes of contractng n the electrcty markets. In ths paper, we nvestgate the dynamcs of market power n the post-reform Russan electrcty market and dscuss how the Russan government handled the ssues of competton and potental market power abuse. We observe that the actual exercse of market power has been qute low and attrbute the result to the bd-at-cost rules enforced va a specal unt commtment procedure on the day-ahead market. The Russan electrcty ndustry reform conssted essentally of two components. The frst component was dvesture of the vertcally ntegrated monopoly nto generaton and transmsson companes and was largely completed n md Further wave of mergers 1 Most notable examples are England and Wales early 1990s (Wolfram 1999) and the Calforna electrcty crss (Borensten et al. 2002). 1

3 among the generators narrowed down the pool of owners n the ndustry, whch suggests stronger potental for market power and hgher prce-cost mark-ups. The second component was market lberalsaton wth the removal of regulated contracts and tarffs and was fnshed by January Regulated contracts were by nature vestng contracts; ther removal from the market meant lower contract cover, stronger ncentves to exercse market power and hgher mark-ups. In order to prevent prce manpulatons n the lberalsed market, the government mposed the bd-at-cost rule on the generators requrng them to bd all avalable capacty at varable producton cost 2. On the Russan electrcty market, the bd-at-cost rule s a part of the unt commtment procedure and the day-ahead tradng. The unt commtment (UC) procedure s run by the System Operator on Frday; for Saturday untl followng Frday nclusve. The generators submt the start-up cost and prce-quantty bds for all avalable capacty for the whole week. The procedure determnes only the start/stop tme of the generaton equpment for the followng week, not the output schedule. The UC prce-quantty bds are used on the dayahead (DA) market as self-enforcng prce caps. On the DA market the generator may submt new bd (whch would determne the actual hourly producton) but the DA bds cannot exceed the UC bds. If a generator submts hgh UC bds he rsks beng dle for the next week, and f he submts hgh DA bds he wll be capped wth hs own UC bds. The Federal Antmonopoly Servce of Russa montors the bddng behavour and may nflct fnes on companes suspected of manpulatng the bds (as was already the case wth several companes). Internatonal research suggests that n lberalsed markets prvate generators use capacty wthholdng as a typcal strategy to exercse market power. 3 A large producer wth several power plants would wthhold some capacty so that a more expensve power plant comes nto operaton (that otherwse would reman dle) and determnes a hgher prce on the market. The actual level of market power s measured by the prce-cost mark-up, where prce s usually a system margnal prce and cost s the system margnal cost of generaton. Snce capacty wthholdng leads to hgher mark-ups (the change n mark-ups dependng of the slope of the supply curve), detectng excessve mark-ups becomes a tool to dentfy market power. 4 Theoretcal results by Allaz and Vla (1993) show that contractng can drve prce-cost mark- 2 The rule to bd all avalable capacty s stpulated n Regulaton 5 of the Market. Fxed cost of producton s recovered separately on the capacty market. 3 Bower et al. (2001) the German market; Borensten et al. (2002) the Calfornan market; Buhn and Olvera (2003) the England and Wales market. 4 Of course, one should exclude other reasonable explanatons for nsuffcent capacty supply and the resultng hgh mark-ups; for example, extreme weather condtons (hence excessvely hgh demand), a transmsson lne falure or other major techncal accdent, amongst other factors. 2

4 up down to zero. A regulatory requrement to bd at margnal cost may be another tool to keep mark-ups low (such a requrement exsts, for example, on the Irsh electrcty market). In Russa, where pre-reform regulated tarffs on electrcty were kept artfcally low, markups would naturally be negatve. Market lberalsaton should lead to prce rses, deally up to the level of generaton cost, and mark-ups would ncrease from negatve values to zero. In other words, ths ncrease n mark-ups that follows lberalsaton does not mmedately sgnal market power abuse. Rather, an ncrease beyond zero (or some other threshold level) would testfy aganst market partcpants suspected of market power abuse. Geographcally, the Russan electrcty market conssts of 28 free flow zones defned by the major transmsson lnes so the market s qute fragmented. Wthn the zones trade s unrestrcted whle nterzonal trade s subject to transmsson constrants. The (already mentoned) post-reform merger wave concerned the companes located n dfferent zones so at frst glance the mergers dd not affect the local level of concentraton (though the stuaton mght change when some smaller zones are ncorporated wth each other n the next few years). Blateral contracts on the market have never been popular, consttutng only 5-10% of the traded volume. 5 In a stuaton where contracts are not wdespread, the requrement to bd all capacty at producton cost was ntroduced on the Russan electrcty market n order to curb market power and keep the mark-ups at a low level. The Russan electrcty supply ndustry went through a large restructurng reform n The reform conssted essentally of two parts: restructurng the ncumbent monopoly called RAO EES and redesgnng the electrcty market. The monopoly was separated nto many generaton companes, grd companes and the system operator. The new market tradng rules ntroduced the commercal operator as well as free prcng and contractng, so that tarff regulaton was eventually abandoned. The transton to free prcng started n January 2007 and took four years to complete. From January 2011, wholesale markets have been lberalsed. In parallel to these two aspects of the reform, our paper focuses on two man ssues of market power: concentraton and mark-ups. Analyss of concentraton provdes nsght on long-term perspectves of market power, whereas dynamcs of mark-ups llumnate the short-term perspectve. Two papers have already examned concentraton on the Russan electrcty market by computng the zonal HHI, whch turned out to be relatvely hgh. Pttman (2007) used the 5 Author s estmate based on hourly data from the ATS, Commercal Operator of the Russan Electrcty Market. 3

5 ndustry structure and market zonng proposed at the start of the reform to compute the HHI ndex, whle Gore et al. (2012) compute the ndex usng the actual free flow zones. Nether of the papers accounted for transmsson flows between the zones whch can be qute sgnfcant as compared to ntra-zone producton. As a part of our study, we re-estmate the HHI gven the fnal ndustry structure, ownershp and mport flows nto FFZ. We fnd that concentraton s severe n some parts of the country, whereas t s qute low n others. Mergers and acqustons seem to have lttle mpact on HHI as the mergng companes were located n the dfferent zones. The mports nto some FFZ act as a sgnfcant compettor to producers nsde the zone and hence the overall stuaton wth concentraton appears less severe. We observe that reducng the number of zones and allevatng transmsson constrants (and unlockng small zones) could sgnfcantly mprove competton n the smallest zones of the market. Durng the transton perod to the free market, the government mantaned electrcty tarffs at a low level, and dd not ncrease them to match producton costs. In such a case, t s natural to expect an ncrease n prces and mark-ups once the regulaton s removed; the sze of ncrease dependng on the dscrepancy between the tarffs and the actual generaton cost. Furthermore, regulated contracts represent a type of vestng contracts used n other countres to curb market power. Removng compulsory contractng creates stronger temptaton to manpulate spot prces and, as such, could lead to hgher mark-ups. In our paper we estmate prce-cost mark-ups n the Russan electrcty ndustry durng 2010 and 2011, namely a year precedng and followng the market lberalsaton on January 1, The mark-ups appear to be low and stable whch contradcts the hypotheses of stronger market power due to concentraton or removal of contracts. We also use a Tobt regresson to quantfy the mpact of the regulated contracts and other counterfactuals on the mark-up dynamcs. Our man fndng s somewhat surprsng: removng prce regulaton decreased the mark-up by about 1.66 percentage ponts. We attrbute the seemng dscrepancy to the bt-atcost rule mplemented n the unt commtment procedure and n the day-ahead tradng. The rest of the paper s organsed as follows: secton 2 presents a bref hstorcal overvew of the Russan ESI; secton 3 dscusses theoretcal measures of market power; secton 4 focuses on ownershp and concentraton n the Russan market; secton 5 deals wth mark-up measures such as the Lerner ndex, the contracts and the mpact of the lberalsaton on the Lerner ndex dynamcs.; secton 6dscuss the results and secton 7 s the concluson. 4

6 2. Russan electrcty supply ndustry hstorcal overvew 6 Ths secton revews brefly the man features of the pre- and post-reform ndustry, wth a focus on market desgn, concentraton and prcng affectng market power. The pre-reform ndustry was essentally a vertcally ntegrated monopoly, under heavy prce regulaton, but endowed wth dspatch functon whch the monopoly abused to exercse market power and earn excessve profts. The post-reform market has problems wth market power that are more smlar to those n other developed and reformed electrcty ndustres. The Russan electrcty supply ndustry n the early 1990s preserved many features of the planned system. The Sovet electrcty ndustry conssted of 72 regonal admnstratons called energos, each responsble for generaton, dstrbuton and supply n a gven area. Total ndustry capacty n 1992 was 213 GW (Russan Statstcs Servce). At an early stage of the reforms, the federal government transferred the bulk of generaton assets under the ownershp of the newly created a holdng company called RAO EES. The process of corporatsaton was not smooth, snce many regonal authortes dsputed control and ownershp of the assets. The fnal property structure thus reflected the ndvdual trade-off and compromse between the federal and regonal governments. By 1996 RAO EES owned, controlled or managed nearly 168 GW out of Some of the regonal generaton companes managed to defend ther ndependent status: together they owned 26 GW. Nuclear power statons (21 GW) were managed separately under the umbrella of the state agency for nuclear generaton. The subsdary companes of RAO EES and ndependent producers were stll responsble for electrcty supples n ther areas. To manage mbalances n local supply and demand, the government created a federal market for electrcty and capacty (called FOREM) and assgned the role of market and dspatch operator to RAO EES. Ths nevtably led to neffcency and a conflct of nterest, because RAO EES was nterested n dspatchng ts own power plants frst, that were relatvely expensve to run (e.g. thermal power plants), rather than power plants of the ndependent producers wth low varable cost (e.g. hydropower generaton). The fnancal stuaton n the ndustry was qute poor. Frst, the general economc stuaton was not favourable to the ndustry: the economy was declnng and so was the demand for 6 Ths secton s largely based on IEA report (1993, 1995) and the book by Xu (2004). See Optz (2000) for an nterm revew; Kennedy (2003) and Tompson (2004) for a bref summary of the reform; Solanko (2011), Gore et al. (2012) and Chernenko (2013) for a more detaled dscusson of the reform. 7 RAO EES (1996) annual report. Total ndustry capacty ncreased by only 3 GW from 1992 to

7 electrcty. Annual consumpton dropped by 23%, from 1068 TWh n 1991 to 826 TWh n 1998; however, power plants were hardly ever shut down and the reserve margn was growng. Probably the man reason s that almost half of thermal staton statons are combned heat and power plants (CHP), whch produce heat for local resdental customers and cannot be mothballed completely. Second, for poltcal and socal reasons, the government mantaned prce regulaton n the electrcty ndustry. Low household tarffs were subsdsed at the cost of hgher tarffs for ndustry customers (see IEA reports 1993, 1995). The problem of cross-subsdy appears extremely senstve as t was not resolved durng the last reform: wth the lberalsed wholesale prces, the low household tarffs are now cross-subsdsed through hgher dstrbuton tarffs for ndustral customers. 8 Fnally, the problem of low tarffs was aggravated by non-payment problems: n 1997 RAO EES collected as lttle as 6-7% of the electrcty bll n cash, 9 the rest beng pad n form of promssory notes, offsets and barter (a typcal problem for post-sovet countres; see Krshnaswamy, 1999). Combned together, low demand, low tarffs and non-payment problem translated nto constant fnancal losses n the ndustry. The scenaro of economc recesson and a hgh reserve margn, combned wth government polcy of low tarffs, resembles the experence of other developng countres not only n the former Sovet Unon but also n Latn Amerca, such as Argentna or Colomba. 10 In Russa, the 1998 fnancal crss reversed the economc stuaton from deep depresson to recovery and subsequent growth, however the problem of low tarffs was only partally resolved durng the lberalsaton reform n 2000s. In terms of market power, the ndustry structure that emerged by the md-1990s seems qute pecular. The domnant monopoly could not manpulate tarffs, yet t had an opportunty to manpulate dspatch schedules, thereby ensurng postve profts (or smaller losses) for tself and ts subsdares. The Russan case seems to be atypcal as other electrcty markets and jursdctons have (or had) a sngle vertcally ntegrated monopoly or at least an ndependent system operator. General dssatsfacton wth poor ndustry performance, coupled wth the economc revval n the late 1990s, provded the background for ndustry reform. After heated dscussons, n The dstrbuton charges for ndustral customers are modfed through the so called last-mle contract; see Chernenko (2013), secton 6.3 for more detals. 9 Source of fgure: Xu (2004), page Dyner et al. (2007). 6

8 the government adopted a programme of complete restructurng of the monopoly and of establshng compettve markets (rather than mnor modfcatons of the monopoly or market desgn). Durng the monopoly and ts dependent energos were re-grouped nto 21 generaton companes. 11 The transmsson dvson was sngled out as the Federal Grd Company FSK, and the dstrbuton dvsons formed a company called Holdng MRSK. The dspatch dvson became an ndependent System Operator, whle the Commercal Operator was created from scratch. The ndependent power producers were also requred to separate generaton and dstrbuton, and create ndependent companes. For the purpose of market operaton, the country was dvded nto two prcng areas, Europe and Sbera, and was further subdvded nto free flow zones (FFZ). 12 The FFZs are defned on the bass of major transmsson constrants (.e. the zones were defned ex ante to the market dynamcs, prce dfferentals, etc.) There are sx FFZ n the Sbera prce area and 22 n the Europe prce area. 13 The electrcty market s based on nodal prcng, whereas the capacty market reles on zonal prcng. In both markets tradng between FFZs s restrcted due to transmsson constrants. Market zonng and composton of the new generaton companes (.e. sze and locaton of ther power plant) and translates nto uneven concentraton level across the country and the potental for market power abuse. There are currently two types of companes: wholesale and terrtoral. A wholesale generaton company, WGC, has large power plants that are dspersed across the country, so as to avod concentraton of assets n a small area. There are eght WGCs, two of them under drect state ownershp. One company became the owner of all nuclear power plants (23 GW n total); the other one receved all major hydropower plants n the ndustry (24.5 GW). The sx remanng companes, each between GW, have large thermal power plants only. A terrtoral company, TGC, has small power plants, CHP and sometmes small hydropower statons; t s located wthn few admnstratve regons. Intally there were 14 terrtoral companes (some of them later splt up nto smaller enttes): ther sze vared greatly from just 600 MW up to 12,880 MW Sx wholesale companes, 14 terrtoral companes and one hydropower company (detals n the man text). Nuclear generaton was, and remaned, under separate state control. 12 There are two non-prcng areas: one at the north of the European part of the country; the other one at the Far East. Both reman under government regulaton. Together they account only for 5% of the capacty and total demand (author s estmate) and ther operaton hardly nterfere wth that of the man markets. 13 In 2013, and subsequently n 2014, some small FFZ are ntegrated wth ther larger neghbours, the total number of zones n the Europe prce area s reduced from 22 to The sze of the ndustry ncreased from 213 GW n 1992 to 225 GW n 2005 (Russan Statstcs Servce). The bulk of capacty s n the prce zones; the non-prce areas account only for 5% of the total fgure. 7

9 The prvatsaton of the generaton companes amed at creatng a pool of compettve nvestors. The process was largely complete by the end of However, the fnal ownershp structure appears qute concentrated gven the small number of Russan holdng companes, n partcular Gazprom the gas monopoly, and a small number of foregn nvestors among the owners. Further mergers and acqustons that nevtably followed n the ndustry threatened competton n the market and challenged the basc prncples of the reform. The new wholesale market for electrcty and capacty, NOREM (based on free bddng and free contractng) began operatng n From January 2007 the government reduced gradually the volume of electrcty to be sold under the tarffs (equvalently, under regulated contracts). 15 Snce January 2011 the wholesale markets have been lberalsed (wth bddng rules n place), and the government restrcts tarff regulaton to prces for households. There was general agreement that the tarffs were too low to cover producton costs, so after the transton perod the prces were expected to ncrease n order to algn wth cost. The man element of the lberalsaton was a regulated contract that stpulated both the amount and the prce (tarff) of electrcty for sale or purchase. The regulated contracts resembled the vestng contracts used n other countres such as England & Wales to smooth transton from the regulated ndustry to a free market. As for the free blateral contracts on the Russan lberalsed market, these do not appear to be popular, n 2011 ther gross share n the traded volume was only 5% (and the fgure dd not change much n 2012). 16 Theory predcts that n such cases market players have stronger ncentves to exercse market power as ther sales and revenue are drectly lnked to spot prces. 17 (The ssue of contracts s dscussed n greater detal n Secton 5 on contracts and mark-ups). A specal feature of the market desgn s a general requrement for generators to bd at full producton cost. 18 The generator should nclude the relevant varable cost of producton, n partcular fuel expenses. Fxed cost (such as mantenance expenses, captal cost, etc.) s recovered on the capacty market. A smlar requrement of bddng at short-run margnal cost exsts, e.g., on the Irsh Electrcty Market where the cost ncludes among others tems the start-up and no-load cost. 19 In Russa, start-up cost s taken nto account durng the weekly 15 Government Decree N 205 ssued on Source of fgures: author s estmate based on data from the Commercal Operator ATS. 17 Allaz and Vla (1993), although others dspute the results, see Murphy and Smeers (2010). 18 See Government Decree N 1172 ssued on , On the Rules of the Wholesale Markets for Electrcty and Capacty, Artcle 18 of the Rules. 19 Bddng Code of Practce (2007), Sngle Electrcty Market Operator (Ireland), avalable at [ 8

10 unt commtment procedure whle man bddng takes place on the day-ahead market. The bddng behavour s montored by the Federal Ant-Monopoly Servce who had already ssued decsons and nflcted fnes on TGC-11 n 2008, MosEnergo (former TGC-3) n 2009 and ByskEnergo (a small IPP) n To summarse, the post-reform electrcty market n Russa s lkely to suffer from concentraton and regonal or local market power, as was the case of other post-reform countres. Gradual market lberalsaton of n Russa removed regulated contracts wthout mposng compulsory contractng (e.g. at free prces) hence the ncentves to exercse market power were amplfed, however the bd-at-cost rule s supposed to mtgate the problem. Further part of ths paper dscusses varous measures of market power, then estmates the concentraton level n the Russan electrcty ndustry and test the hypothess of actual market power abuse. 3. Market power theoretcal measures Market power s defned as the ablty to alter prces proftably away from the compettve level 20. Study of market power, or ndeed any ssue of competton, requres defnton of the market n terms of product and geography. In case of electrcty, the need to constantly balance supply and demand adds tme dmenson to ths defnton. Electrcty s a standard product, subject to voltage, frequency and other techncal requrements. As for geography and tme, these must be examned jontly. Frst, almost any electrcty market exports and mports energy, so mere geographcal or admnstratve bounds are not suffcent to defne a full set of supplers and consumers. Second, as demand vares durng the day and throughout the year, some transmsson lnes mght be congested and some areas mght become solated (even for a few hours a year). Consequently, a geographcal market mght expand or shrnk accordng to demand fluctuatons. Tradtonally, anttrust regulatory authortes have reled on concentraton measures to evaluate competton n the ndustry, for example, the Herfndahl-Hrschman (HHI) ndex. Specfc features of electrcty market requre more sophstcated measures, of whch we wll dscuss the Resdual supply ndex (RSI), together wth the Transmsson-constrant RSI, and the Lerner ndex. We also dscuss the role of contracts n mtgatng market power. 20 The defnton s standard and can be found, e.g. n Mas-Colell et al. (1995), page 383, or Stoft (2002), page

11 The Herfndahl-Hrschman ndex s a concentraton measure used by many competton and ant-monopoly authortes to examne the potental for market power n the ndustry. HHI s 2 computed as the sum of squared percentage shares ( HHI ( s ) where s j s the percentage share n total output) and ranges from 0 to 10,000. Accordng to the US Department of Justce, a market wth HHI below 1,500 s not concentrated, a market wth HHI between 1,500 and 2,500 s moderately concentrated and a market wth HHI above 2,500 s hghly concentrated 21. On the electrcty markets HHI s usually based on nstalled capacty (accountng, f necessary for export and mport capacty), but for several reasons dscussed below t s a poor ndcator of market power. In the electrcty ndustry, market power can be exercsed ether by physcal capacty wthholdng or by bddng above compettve prces. Any generator n prncple may attempt to wthhold capacty, whereas a margnal generator (.e. one that s the last to be used to meet the demand and whose bd determnes the equlbrum prce) also has ncentves to attempt to rase the prce. Ether behavour leads to an upward shft n the supply curve and to the dstorton of the equlbrum prce and output: the prce s ncreased and the output s decreased. 22 Full nformaton on plants thermal effcency and fuel prces would make bddng above margnal cost very unlkely, as such behavour can be easly detected. Moreover, hstorcal nformaton on outages makes capacty wthholdng less probable. From a practcal perspectve, a recently lberalsed market typcally has a comprehensve data set on plants effcency n the publc doman, nherted from the pre-reform utlty company. As the market develops, nformaton on outages s accrued, e.g. by the Independent System Operator and/or the regulatory authorty, who are then able to montor the generators for market power abuse. Standard IO models do not dstngush between potental for and actual exercse of market power (e.g. a standard monopoly s assumed to exercse market power by default). 23 In electrcty markets ths dstncton s mportant, snce demand vares durng the day and shortrun demand s known to be nelastc. 24 There s lttle sgnfcance n exercsng market power j j 21 U.S. Department of Justce and Federal Trade Commsson (2010) Horzontal Merger Gudelnes, See Stoft (2002), page 320, fgure 4-1.1, and the related dscusson of quantty wthholdng, quantty and prce dstorton 23 By defnton, exercsng market power n market s assumed to be always proftable and a ratonal frm s expected to exercse market power f there s an opportunty to do so (e.g. a monopoly would always rase ts prce above the compettve level). 24 See, for example, paper by Borensten et al. (1999) on the sutablty of concentraton measures for the competton analyss of the electrcty ndustry. 10

12 when the demand s low or, n other words, when there s enough spare capacty. A margnal generator that attempts to wthhold capacty or bd above the compettve prce s very lkely to be replaced on the market by another (dle) producer. By contrast, market power abuse s more probable when demand s peakng (.e. when there s lttle spare capacty and demand does not respond much to prce changes). In such crcumstances the margnal producer mght fnd t proftable to reduce output, perhaps by a small amount, to nduce a large prce spke and enjoy excessve profts. Snce t s actual producton, not nstalled capacty that matters, HHI based on capacty s a poor ndcator of market power (although t can ndcate long-run postons of the producers on the market). A relatvely small ndependent producer mght be margnal on the market and hence enjoy consderable market power durng peak perods. To assess the mportance of any suppler should t become margnal, or pvotal, the Calforna s ISO (CAISO) developed the Resdual Supply Index. The RSI s computed as follows, for each hour n the year (Sheffrn, 2002): RSI Total Supply - Largest Seller's Supply Total Demand The RSI screen test states that the ndex should be more than 110% for more than 95% of the hours s a year. Sheffrn observes the RSI exhbts strong correlaton wth the Lerner ndex and thus can serve as a good proxy for actual market power, wthout the need to estmate producton costs, equlbrum prces and mark-ups. Swnand et al (2008) provde a theoretcal model based on frm s resdual demand that lnks together frm s ndvdual mark-up, RSI and absolute demand elastcty: 25 P MC 1 RSI. P Indvdual prce-cost mark-up s nversely and lnearly correlated wth RSI. Moreover the ntercept and the slope are equal n absolute terms so that the relatonshp can be easly verfed emprcally. The RSI was developed for a sngle-zone market wthout major transmsson constrants. Lee et al. (2011) ponted out that the ndex s not sutable for a market whch uses locatonal margnal prces and wheren many lnes are congested for a sgnfcant number of hours. They 25 See the Appendx 1.Model 3C for detals. 11

13 offered a transmsson-constraned RSI (TCRSI) whch s computed for each a generaton company as s.t. where max R qt, k RF usng a smple lnear programmng model: 26 F q x R D, k, k k j s k, j q k x k K k, k, j k k x T, { j} j j s s q x 0, s F j R F transmsson-constraned RSI for frm F, s ndex of the generatng unt for whch TCRSI s computed, {1,...,28} ndex for free flow zones, k {1,...,139} ndex for a generaton unt, contnuous numberng, k q output of unt k located n zone for n-zone consumers, k x output of unt j k located n zone for export to zone j, D demand n zone, k K nstalled capacty of unt k located n zone, T j transmsson constrant from zone to zone j, Note that Tj (2.3) (2.4) (2.5) (2.6) (2.7) T as the actual network topology may results n dfferent lmts on the aggregate flows from to j and from j to. s F all generaton unts s that belong to frm F for whch TCRSI s computed, The TCRSI s estmated for the hour of peak demand only; consequently t s more sutable to evaluate market power n the long run. By contrast, computng the ndex for all hours n a year would provde nsght nto short-term power abuse and ndcate whch congested lnes requre renforcement or an ncrease of ther transmsson capacty n the frst place. The Lerner ndex s ntally developed for the case of the monopoly (see Appendx 1. Model 3A for a formal model). The ndex s wrtten as LI ( P MC) / P where P s the market prce and MC s margnal cost. In case of the monopoly the ndex s nversely proportonal to the absolute elastcty of market demand: LI 1/. When the demand s nelastc, the monopoly has stronger ncentves to rase the prce wthout losng too many j 26 The model s also replcated n Appendx 1. Model 1. 12

14 customers and hence t would gan extra profts. The model s then extended to Cournot olgopoly (Model 3B) to derve frm-specfc and ndustry-average Lerner ndces whch are also nversely proportonal to demand elastcty. In addton, the frm s ndex s proportonal to the frm s share of the market, LI s /, and the ndustry ndex s proportonal to the concentraton as measured by the Herfndahl-Hrschman ndex, LI HHI /. As dscussed above, when electrcty demand s low, generators have lttle ncentve to manpulate capacty; hence observed prces are expected to be close to margnal cost. When demand s hgh and supply of capacty s tght, prces may ncrease due to demand-ratonng rules (absent prce caps on the market) or due to market power abuse. The curve of observed prces would be steeper than the supply curve, and the mark-up curve would be ncreasng (fgure 1, left pane). In an electrcty market wth must-run generaton (that has zero-prce bds) the left part of the supply curve s zero, so the mark-up curve would start at one and then return to a normal ncreasng curve (fgure 1, rght pane). Fgure 1. Mark-up dynamcs on electrcty markets wthout and wth must-run generaton. Examnng the Lerner ndex ndcates that there are essentally two ways to reduce market power: by ncreasng demand elastcty or by reducng ndvdual share n total output. The frst opton s not feasble n the electrcty market, snce most consumers, partcularly households, do not have an opportunty to respond to real-tme prces. The second opton mght mply stronger competton (e.g. through reallocatng more evenly the output among the exstng producers or through new entry). Ether opton s costly because t requres 13

15 constructon of new capacty by frnge or new producers and does not help mtgate market power n the mmedate future. However, reducng frm s sales n a spot market, through forward contracts, reduces frm s ncentve to manpulate the spot prce. Consequently, forward contractng becomes another way to mtgate market power, wthout alterng the number of compettors or the total demand. Allaz and Vla (1993) presented a theoretcal framework of a duopoly wth lnear demand, constant margnal cost and forward contractng. They showed that when the number of forward tradng perods tends to nfnty (or equvalently, when tradng becomes more frequent), compettors sell forward n the frst perod and attempt to contract the resdual demand n the future perods (to beat each other) so that the uncontracted demand eventually vanshes to zero. The ncentves to ncrease the spot prce above margnal cost dsappear, hence the duopoly prces and output tend towards those n perfect competton. Other papers modfed the model under consderaton, such as the supply-functon framework (Green, 1999) or Bertrand competton (Mahenc and Salane, 2004). Bushnell (2007) extended the model to olgopoles wth ncreasng margnal costs and calbrated the results to several US markets. He concluded that, under certan condtons, forward contractng s equvalent to ncreasng the number of supplers from n to n 2, or n other words, to ntroducng stronger competton Wth large volume of forward contracts, the generator has lower ncentves to manpulate the spot prce as t only affects the uncontracted demand. It can be shown that both the RSI and mark-ups are also smaller. In a stuaton where a generator s over-contracted (.e. has to sell more energy under forward contracts than t s wllng to produce gven ts current cost structure), t acts as a buyer on the spot market and s more nterested n lower spot prces. Hence, the ncentves for manpulatng the spot prce are reduced greatly, f not removed completely. In summary, to detect market power abuse n the electrcty market, one should use measures based on uncontracted output and cost rather than on nstalled capacty. Estmatng the Resdual Supply Index and Lerner Index s preferred, although HHI can be used for analysng long-run perspectves on the market. Snce demand s very nelastc n short-run and constructon of new power plants and lnes requres a long tme, forward contractng s an nstruments that can be mmedately enforced n the market by the regulatory authortes to mtgate market power. 14

16 4. Ownershp and concentraton n the Russan ESI The prvatsaton of the RAO EES power plants amed at attractng prvate nvestors to the ndustry. A varety of prvate shareholder would guarantee, at least ex ante, competton between producers. However, the fnal number of owners turned out to be qute lmted. The ownershp of the major generaton companes n the ndustry at the end of the unbundlng process and three years later s gven n table 1. Despte efforts to prvatse the new generaton companes, the federal government appeared among the man stakeholders. The state-owned Gazprom and ts subsdares secured control n four generaton companes wth total capacty of 36 GW. The prvate Russan holdng IES, Integrated Energy Systems, acqured shares n another four companes (15 GW n total), and the Sberan coal-mnng holdng SUEK bought TGC-12 and 13 (7 GW n total). Other generaton companes each have a separate owner, ether a Russan or a foregn nvestor predomnantly from the energy ndustry. In partcular, E.On (Germany) acqured the Fourth WGC and Enel (Italy) bought the Ffth WGC, whle Fortum (Fnland) became the owner of the terrtoral company TGC-10. Not all generaton companes found new owners and nvestors. The frst WGC was not sold to anyone and, as a temporary measure, was transferred to the FSK, the natonal grd company. In other words, the cornerstone prncple of the reform, separatng transmsson from generaton, was volated, albet for a short perod. Once an owner, the FSK transferred the votng rght, and subsequently sold the shares, to the InterRAO company. From 2008 to 2011, the stuaton has changed drastcally. After a seres of mergers and share acqustons through Gazprom and the InterRAO company, the federal government renforced ts poston as the man stake-holder. InterRAO was ntally a small state-owned producer but endowed wth a monopoly on cross-border electrcty trade. The company had a few power plants near the state borders of total capacty GW. As a result of the acqustons, InterRAO has now sgnfcant shares n fve generaton companes, between 20-40%, so that the amount of capacty under ts control n proporton to the shares s around 23 GW. As a result, the two aforementoned companes together control about 42.6 GW or 25% of the nstalled capacty on the wholesale market. The pre-merger companes had power plants n dfferent zones so that competton wthn one zone seems unaffected, yet the stuaton may change when some of the zones are ntegrated wth each other (see below). 15

17 In short, Gazprom and partcularly InterRAO, beng both state-owned companes, are used by the government to undo prvatsaton. The core dea of the reformed market where producers would compete aganst each other s put at rsk, f not rejected. A thorough study of concentraton n the Russan ESI was done by Pttman (2007). The author estmated the HHI of the sx dspatch zones of the country 27 at the start of the reform gven the then-proposed ownershp of the power plants. The HHI based on the nstalled capacty n each dspatch zone ranges from 1,318 to 2,460, whch ndcates moderate concentraton. The author then ams to show that concentraton measured as a cumulatve share of the largest n power plants n the area dffers from season to season by accountng for seasonal varaton n hydropower capacty (the largest capacty s n the sprng, the lowest s n the wnter) and baseload status of CHP (baseload n the wnter and peak n the summer). He argues that n wnter concentraton s hgher and competton s worse as fewer power plants compete for non baseload demand. In sprng, the state-owned hydropower plants have larger producton capacty and as a results larger market share, whch also threatens competton. Pttman conducted hs research when the exact market zonng was not clear yet, so he used the techncal dspatch zones (the smallest unts avalable at the tme) and, because the dspatch zone are qute large, he dd not have to consder mport flows. Gore et al. (2012) offered an estmate of the HHI n 2008 gven the new market zonng and ntal ownershp structure, however they dd not account for mports ether. For example, a company that has power plants n a gven zone typcally also has plants n the neghbourng zones, and t mght manpulate mports n order to nfluence supply and prces n the gven zone. We suggest reestmatng the HHI as of 2011 and ncludng mports n the calculaton. Consderng all possble company-specfc mports would complcate the analyss heavly so and shall treat all nflows to a gven zone (a) as one ndependent suppler, or (b) f the mport share s hgh enough, n pro-rata to the nstalled capacty of companes from the export zones. More precsely, the mport s the maxmum of total hourly nflows durng the year The results are presented below n fgure 2 and the detaled calculaton can be found n Appendx 2, Table The total number of the dspatch zones s seven; the Far East zone was not consdered n the study. 16

18 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, Free flow zones HHI (mport as one suppler) HHI (mport pro-rata) HHI n 2008 (Gore et al., 2012) Fgure 2. HHI for free flow zones, mport as one suppler and mport pro-rata. Our calculatons show that pror to the merger wave none of the free flow zones have HHI suffcently below 1,500, that s all zones are moderately or hghly concentrated. Two lowest HHI values are 1,466 n zone 7 Ural and 1,606 n zone 24 Centre. Four other zones have HHI between 2,000-2,500. These zones are ether bg n sze and/or wth relatvely mld transmsson constrants. The medan HHI value s 3,915 and the weghted ndex s 2,763.Many small zones have at most one TGC, maybe supplemented by one or two power plants of some WGC, and qute strong transmsson constrants, so they are hghly concentrated. Correctng for the mergers, the HHI ndex does not change dramatcally. The man reason as mentoned above s that the pre-merger companes generally operated n dfferent free flow zones. Yet, after the zone ntegraton the ssue of mports and cross-zone market power mght become more senstve. Accountng for mports n proporton to nstalled capacty of the companes from export zones ndcates that the concentraton mght be not so severe. The two zones wth HHI above 9,000 have the ndex dropped to 6,487 (zone #22) and even to 2,937 (zone # 9). Many other zones also have lower HHI by 400 1,500 ponts (as compared to the one-suppler case). Whle the study by Pttman and our HHI estmates hghlght the mportance of zonng and transmsson constrants, evaluatng the TCRSI for each staton provdes further nsght nto 17

19 the problem. Statons wth TCRSI below one (.e. those ndspensable for meetng local demand) are typcally located n smaller zones wth weak transmsson lnks to the rest of the market. The nstalled capacty of the staton mght be relatvely small (e.g. as lttle as 100 MW) but gven the small sze of the zone and lmted potental for mports, wthdrawng such a staton from the market (for example as the result of an outage) may lead to load sheddng. Any generaton company that has plants n such small zones can potentally exercse market power, by declarng the whole plant, or some generaton blocks, unavalable. There are three clusters of smaller FFZs that appear partcularly senstve to plant outages. The frst cluster s located n the south of Sbera, the second cluster s n the Ural regon and the thrd one s n the south of Russa (the latter two are n the Europe prce area). Each of the zones has between one and three statons, typcally thermal power plants and a CHP, sometmes combned wth a medum-szed hydropower plant. Estmatng zone-based HHI and transmsson-constraned RSI ndcates the need to unlock small free-flow zones n order to mprove effcency. Constructon of new lnes and modernsaton of network equpment s already a major part of the FSK nvestment programme. The results are promsng: from 2013 the System Operator wll ntegrate four smaller zones nto ther respectve larger neghbours, and from 2014 there wll be further ntegratons of two other small zones, so that the total number of FFZs wll be reduced from 28 to 22.Some of the ntegraton wll take place n the south of Russa and wll clearly mprove competton n that area. To summarze, the unbundlng of RAO EES's monopoly and prvatsaton of new generaton companes offered an opportunty to create a pool of compettve owners and ensure competton on the market. Subsequent mergers and acqustons created a moderately concentrated ndustry, where the federal government has the largest stake. Further consoldaton of the assets would most probably be detrmental to competton. In addton, market zonng complcates the stuaton, but the network renforcement currently mplemented by the Federal Grd Company should allevate the stuaton n the near future. 5. Mark-up dynamcs Havng examned long-term prospects for market power, we shall now dscuss short-term dynamcs, n the context of market lberalsaton. We wll frst descrbe the prcng rules and the role of contracts n the Russan electrcty ndustry durng and after the reform, then present a model to evaluate prce-cost mark-ups and assess ther dynamcs over the course of 18

20 lberalsaton. Our man fndng s that mark-ups have reduced as a result of removng tarffsths s qute surprsng gven that one would normally expect an ncrease. However, examnng the mark-up dynamcs before and after the lberalsaton produces more consstent results Lberalsaton and types of contracts As part of the reform, the wholesale market for electrcty and capacty was completely redesgned. The fnal am was to replace tarff regulaton (whch proved to be neffcent) wth free prcng and contracts that would ensure effcent producton and consumpton (.e. producton by the lowest cost generators and consumpton by customer wth the hghest prce bd). Gven the sze of the ndustry and the novelty of the tradng approach, tarff regulaton was not removed overnght but rather reduced gradually over tme. The approach s not unque: other countres (e.g. England & Wales) used vestng contracts to ensure smooth transton from the regulated ndustry to the free market. In Russa, snce January 2007 the volumes of electrcty sold under the tarff have decreased by percentage ponts every sx months. Consequently, the volume of electrcty n the free sector of the market was constantly ncreasng. Snce January 2011 the wholesale market s fully lberalsed. As for the retal market, small commercal customers receved an opportunty to freely choose ther supplers, whereas households stll buy ther energy at the regulated prces from the suppler apponted by the regonal authorty. Fgure 3 depcts the actual shares of the regulated sector (measured as the rato of volume sold under tarffs to the total volume traded) versus the lberalsaton schedule. It s nterestng to observe that the actual share of regulated contracts was n lne wth the scheduled level n the early stages and somewhat above the scheduled level n the later stages. A possble (although certanly not the sole) reason for such dscrepancy could have been the fnancal crss that ht the economy n late The share of the regulated contracts was measured wth respect to the 2007 producton volume, and the respectve amount of regulatory sales was fxed for the whole perod of lberalsaton. When the total demand decreased n , the share of regulated volume (fxed at the 2007 level) ncreased naturally. 19

21 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Lberalsaton schedule Regulated contract, actual Fgure 3. Lberalsaton of the Russan electrcty market: schedule and actual pace. Once the market was lberalsed, regulated tarffs and contracts dd not dsappear from the market. Russan households stll buy electrcty at fxed retal prces from apponted supplers, who, n turn, buy electrcty on the wholesale market under regulated wholesale tarffs only. The practce s mposed by the government n order to elmnate prce rsk for the apponted supplers. The share of such contracts n 2011 fluctuated around 15%, correspondng to a share of household consumpton of 12% (cf. 26% n the EU-27). 28 The rest of the wholesale electrcty market, ncludng purchases for non-household retal supply, s fully lberalsed. The free sector of the market conssts of free contracts and a centralsed power exchange. Durng the transton perod the market had contracts for electrcty and capacty, as well as contracts for electrcty only. The jont contract was a popular tool to secure supply n peak hours, albet the gross volume contracted was not very sgnfcant. In a peak hour, the contracted volume could reach 26% of the total amount traded, whle the annual share of such contracts was a mere 5%. 29 Wth the lberalsaton of the capacty market and the ntroducton of long term capacty auctons, jont contracts are no longer n use. Only pure electrcty contracts reman on the market, but they are not wdespread ether: a share of the contracted volume never exceeds 10% n any one hour. Nonetheless, the annual share of such contracts s also 5% whch ndcates more even use throughout the year. 28 Source of fgures: share of contracts 15% - author s estmate based on data from the Commercal Operator; household share n consumpton n Russa 12% - Russan Statstcs Servce; household share n consumpton n EU 26% - OECD. 29 All fgures n ths paragraph are author s estmates based on hourly data from the Commercal Operator. 20

22 The regulated contracts used n the Russan electrcty market by nature represent the vestng contracts used n other countres to ensure smooth transton from the regulated ndustry to a free market (e.g. n England and Wales). The vestng contracts facltate the transton but snce they expre wthout a requrement for renewal, they help mtgate market power only n the short-term. Free contracts do not appear popular on the Russan market, so the ssue of market power remans unsettled Estmatng benchmark prces and the Lerner ndex To evaluate the role of contracts n market power, we frst need to estmate the Lerner ndex, whch s a conventonal nstrument to estmate prce-cost mark-up on the electrcty market. The ndex s computed as LI ( P MC) / P and s evaluated n emprcal studes as LI ( P actual MC estmate ) / P actual. Gven that MC s unobservable, we estmate the unt producton cost of the margnal plant, and hence the equlbrum prce, usng the lnear programmng model. In the model, the objectve functon mnmse total cost of meetng demand n each hour gven nstalled capacty and transmsson constrants (full detals can be found n the Appendx 1.Model 2). Our estmate consders only fuel cost, so an ndex below 20% s not very nformatve. Rather, t s relatve changes n the Lerner ndex (n partcular, spkes or shfts n the trend) that would ndcate the exercse of market power. The model generates equlbrum, or benchmark, prces for all 28 zones. Fgure 4 presents the Lerner ndex for the three largest FFZs no. 1, 7 and 24 over two years (smoothed by MA 28-days flter).the tme seres appear to be stable, wth humps n the summer perods. The model estmates the prce to be very low durng the summer due to small demand, but the actual prce appears somewhat hgher (perhaps due to techncal requrements), so the Lerner ndex looks excessve. The summary statstcs are gven n Appendx 2, Table 2. 21