Strategic Investment in Merchant. Capacity Utilization Rules

Transcription

1 Strategic Investment in Merchant Transmission: the Impact of Capacity Utilization Rules Federico Boffa (University of Macerata) Francesca Sala (Competition Commission, UK, and Econpubblica, Universita' Bocconi) IEFE-Bocconi, Milano, 10 Settembre 2010

2 Merchant Transmission Investment Merchant Transmission Investments: As opposed to regulated investments (natural monopoly) Private investors investing in transmission capacity receive the right to collect congestion revenues equal to the difference in nodal energy prices associated with the incremental nodal point-to-point p transmission capacity their investment creates.

3 The congestion revenue K: transmission capacity

4 Aim of the paper Merchant Transmission Investments As opposed to regulated investments (natural monopoly) First proposed by Hogan (1992), Bushnell and Stoft (1996, 1997), and Chao and Peck (1996). They propose a model that relies on competition, free entry and decentralized property-rights rights based institutions, and market price-based transmission service to govern transmission investments. In return for investment in additional transmission capacity, merchant investors receive property rights on the line that allow them to collect congestion revenues equal to the difference in nodal energy prices associated with the incremental nodal point-to-point to transmission capacity their investment creates.

5 Definitions Merchant Transmission Investments: market based remuneration; the investor receives the right to collect the congestion revenues, i.e., difference in energy prices between the two interconnected markets. Must-offer provision: all the installed capacity must be made available to the market; with limited transmission capacity, flows match capacity.

6 Congestion G1 Suppose D(t) is perfectly inelastic w.r. to price. D(t)=500 Both B G1 and G2 can generate up to 500. G1 is more cost-efficient. However, the capacity of A is limited to 400. Thus, when D(t)=500, a congestion problem arises, and t has to be supplied by the least efficient generator e A G2 Town

7 Motivations International regulations: MTI is a tool to stimulate transmission investments (e.g. U.S., Australia, EU); however, institutions count! MTI needs an appropriate market design : alternative institutional designs produce different market outcomes; the paper analyzes the features of this mechanism.

8 Motivations EU legal framework In Europe, MO provision does not exclude existing interconnectors: EU regulation on interconnection (July 2004) explicitly requires TPA for interconnectors While new investment can be exempted from TPA (art. 7) does not exempt new interconnectors from MO;

9 Goal Compare the performances of: must-offer rule, against non must-offer rule under strategic investments, in a one-period and in a two period setting, in terms of: market outcomes; entry possibilities; consumer surplus; social welfare; collusive prospects. p

10 Outline Definition and background Literature review The model one period Welfare results The model two periods Collusion Generalization Policy implications

11 Literature Review: MTI Theoretical literature on MTI: Hogan 1992; Bushnell and Stoft 1996, 1997; Chao and Peck 1996 MTI and financial transmission rights efficiency. In a perfect market, optimal allocation of resources. Joskow and Tirole 2005 MTI with market imperfections inefficiency Brunekreeft and Newbery 2005 review of policy issues related to Mo rule

12 Lumpy transmission investment

13 Preemption

14 Literature Review: Strategic Investment Theoretical literature on Strategic Investment, motivated by the features of the Mo arrangement: Bain (1956) examines the role of capacity investment as a strategic commitment device capable of affecting the market structure in a given industry Dixit (1980) illustrates the strategy of sinking a portion of their cost in the investment stage thereby committing to a more aggressive strategy in the successive production stage. Fudenberg and Tirole cathegorize sequential strategies (top dog and puppy dog) Eaton and Ware 1997 lay out a theory of sequential entry

15 Outline Definition and background Literature review The model one period Welfare results The model two periods Collusion Generalization Policy implications

16 The model R i Standard setting: two-node network, no losses; optimal dispatch and nodal energy prices; generation cost lower in the North than in the South perfect competition in wholesale energy markets; two (profit-maximizing) merchant investors: FM and SM; identical affine capacity cost functions: C FM k FM F rk FM Linear revenue functions: q FM, q SM q FM q SM q FM q FM q SM q FM where eta is the difference in nodal prices

17 Timing and first mover advantage 1 E 2 SO FM chooses SM decides Active firms transmission whether or not simultaneously capacity k FM to enter choose flows q FM (and capacity k SM and k 0) I Equilibrium nodal prices are set and payoffs accrue Sunk capacity costs rk FM Fixed setup cost F Output marginal cost 0 up to capacity r otherwise

18 Must offer game I Post-entry game: flows must equal capacity. With sequential entry, regulatory commitment for FM to fully use capacity; FM Stackelberg leader in output, SM Stackelberg follower; entry decision by SM and capacity choice by FM depend on fixed set-up costs F; when F is high, the entrant does not find it profitable to enter even if FM plays the unrestricted t monopoly output; t otherwise, FM faces a decision: accommodation versus deterrence.

19 Accommodation versus deterrence Accommodation. FM anticipates that SM will enter, and behaves as a Stackelberg leader in output. Deterrence FM prevents SM from entering; commits to a higher output than under acc. (denoted as q I L), so that the potential entrant does not find it profitable to enter (he would be left with a too small market share, that would not repay him of the fixed entry cost); sometimes (when F is very low) deterrence requires a commitment to a very high output, hence it is not optimal. Under Mo, deterrence is always feasible: commitment provides the Mo arrangement itself.

20 Must offer game II SPN equilibria D F Mo B F Mo F F sufficiently low F intermediate F high Accommodation Deterrence Unconstrained monopoly Stackelberg equilibrium Limit capacity (and output) Monopoly capacity (and output)

21 Non Must Offer I Post-entry game: flows may be lower than capacity: with sequential entry, commitment for I to fully use capacity relies only on sunk capacity costs. They allow the incumbent to commit to a more aggressive strategy (raising q I A). Given k FM I solves:

22 Non Must offer game II Accommodation game: if r high, Stackelberg equilibrium can be achieved (S); if r low, asymmetric Cournot equilibrium prevails (A), i.e., I can exercise limited leadership. Deterrence: if r high, it provides I with a sufficient commitment device to deter entry (because q FM L<q FM A for the relevant values); if r low, deterrence is not feasible (even though I installs a high capacity, it would be suboptimal to use after E enters, as q FM L>q FM A; therefore, I does not build a high capacity in the first place).

23 Non Must offer game graphs q E q E k R I r high k R I r low R I R I C q E A q E C S A C q E q A E C A S R E R E C q I k I A q I qi C q I q A I k I qi Stackelberg equilibrium Equivalent to Mo Asymmetric Cournot equilibrium NMo and Mo differ

24 Non Must offer (r low) I Entry decision by E and capacity choice by I depend on fixed set-up costs F: but with r low I's first-mover advantage is reduced; entry deterrence never a credible strategy; it is impossible to commit to an aggressive strategy (q I A is very close to the symmetric Cournot output).

25 Non Must offer (r low) II SPN equilibria ii i F D Mo F B Mo F B NMo F F low Accommodation F very high Unconstrained monopoly Asymmetric Cournot equilibrium Monopoly capacity (and output)

26 Results: feasibility of deterrence Block and deterrence under Mo are feasible for a larger set of outcomes than they are under NMo: Under Mo, the institutional arrangement itself guarantees the credibility of the "threat" of making the full built capacity available; on the other hand, under NMo, the credibility of the threat hinges on the magnitude of sunk costs; block or deterrence can be appealing strategies for FM; however, while under Mo they are always feasible, under Nmo their feasibility requires q FM L<q SM L A.

27 Results: profits involved by the two regimes The incumbent's profits are higher under Mo when the variable cost is low, while they are equal when the variable cost is high. h Three reasons for that: t blockading entry under Mo requires q L <q M, while under NMo it has to be q L <q M <q A. Hence, more block (unambiguously increasing profit) under Mo; feasibility of entry deterrence under NMo requires q L <q A while under Mo deterrence is always feasible; how this affects profits depend d on the relative position of q L and q A under Nmo, it may be that the optimal (Stackelberg) output is not feasible, i.e., when q S > q A ; under Mo, on the other hand, the Stackelberg outcome is always attainable Counterintuitive? Constraint providing a commitment

28 Entry and output decisions With r low, Mo rule: reduces E's Es entry chances: by making entry deterrence a credible strategy for I; by increasing the scope for I to exercise unconstrained monopoly power; makes I more aggressive post-entry.

29 Market outcome under Mo and NMo When r is high, Mo and Nmo yield exactly the same outcome. When r is low: for low F, accommodation in both games, but under Mo lower quantity by E; for intermediate F, entry is deterred under Mo, while it is accommodated under NMo; f l F t i bl k d d d M hil it i for large F, entry is blockaded under Mo, while it is accommodated under NMo.

30 Outline Definition and background Literature review The model one period Welfare results The model two periods Collusion Generalization Policy implications

31 Consumer surplus CS increases as total transmission capacity increases Mo rule CS under accommodation and under deterrence with F very low since K ; Mo rule CS under deterrence with F high and under monopoly since K

32 Consumer surplus as a function of F - I Low F: entry acc. under both regimes. Stackelberg (Mo) entails a higher total transmission capacity than the asymmetric Cournot (Nmo). Mo increases CS. Relatively low F: det. under Mo and acc. under Nmo. q L is decreasing in the fixed cost F. With relatively low F, E enters even when it can produce a relatively low output. Hence, I needs high capacity to deter. MO increases CS.

33 Consumer surplus as a function of F - II Relatively high F: det. under Mo and acc. under Nmo. Es E s break-even even output increases, so q L lower. MO decreases CS High F: block under Mo, acc. under Nmo. Mo decreases CS.

34 Consumer surplus II (Acc, Acc) (Det, Acc) (Mon, Acc) (Mon, Mon) D F Mo B F Mo B F NMo F C A F F F B ΔCS 0 ΔCS 0 ΔCS 0

35 Total welfare Mo rule: W under accommodation (K ) and deterrence with F low (no duplication of F); W under deterrence with F high (K ) andmon (K ) W under deterrence with F high (K ) and mon. (K ), unless r very low and F very high

36 Total welfare as a function of F Low F: analogous to CS. Mo increases TW. Higher F: det. or block under Mo and acc. under Nmo. Relative desirability of MO increases, because it avoids duplications of fixed costs. MO is preferred to Nmo for a larger range of variable costs.

37 Total welfare II (Acc, Acc) (Det, Acc) (Mon, Acc) (Mon, Mon) D F Mo F B Mo F B NMo F C A F F F B ΔW 0 ΔW 0 r r ΔW 0 ΔW 0 r r ΔW 0 ΔW 0

38 Outline Definition and background Literature review The model one period Welfare results The model two periods Collusion Generalization Policy implications

39 Assumptions Two periods: peak period has a demand for electricity P₁=a-b₁Q₁; ₁ ₁Q₁; offpeak (i.e., in the base period), the demand for electricity is: P₂=a-b₂Q₂, whereb₁<b₂; on peak higher elasticity than offpeak; derived interconnection demands: P₁ = αβ-β₁q₁ and P₂ = αβ-β₂q ; technical assumption α₁=((α₂β₂)/(β₁)), implying that maximal willingness to pay for interconnection capacity does not vary across periods; Start with analysis for the monopoly case.

40 NMo marginal benefits with two periods

41 Mo marginal benefits with two periods

42 Marginal benefits under NMo Under NMo: as long as the capacity stock is smaller than the optimal output in both markets (and, namely, as long as the capacity stock is smaller the monopoly output in the offpeak period), an increase in capacity increases the revenue in both markets; however, as soon as capacity hits the revenuemaximization level in the offpeak period, any extra addition in capacity is used only during peaks, as its utilization offpeak as well would reduce the offpeak revenue

43 Marginal benefits under Mo Under Mo: Even after capacity hits the revenue-maximing level offpeak, the further additional capacity has to be used in the base period as well (precisely because of the Mo rule), even if this determines a negative marginal revenue in the base period); The additional investment ceases to be utilized offpeak only when the offpeak-period competitive output is hit, and the offpeak interconnection price is null (given the implicit constraint that η 0). This generates the discontinuity shown before. Additional disincentive to invest prompted by Mo.

44 Comparison between the two games

45 Results for capacity Under r 1 Mo and NMo yield the same result. Even under Mo, it is convenient to build as well capacity that is used exclusively in the peak period. Under r₃ Mo and NMo yield the same result. Even under NMo, it is not convenient to build capacity that is used exclusively in the peak period. Hence, under both arrangements (NMo and Mo), it is more convenient to build only capacity that can be exploited in both periods. Under r 2 Disincentives to invest generated by Mo.

46 Results for quantity Results for quantity are more ambiguous While the capacity investment is higher under NMo, under Mo the investor has to use it in both period, and this acts in part as a counterveiling effect. Still NMo tends to generate superior quantity Mo and NMo yield the same result. Even under NMo, it is not convenient to build capacity that is used exclusively in the peak period. Hence, under both arrangements (NMo and Mo), it is more convenient to build only capacity that can be exploited in both periods. Under r 2 Disincentives to invest generated by Mo.

47 Blockaded entry Two considerations Given the same monopoly quantity in both periods, Mo (weakly) reduces entrant s profits. But quantity may differ in the two arrangements. When quantity is higher under Mo in the base period, and same in the peak period: Mo unambiguously increases block opportunities. When total quantity is higher under NMo Two counterveiling forces, depends on which of them Two counterveiling forces, depends on which of them prevails.

48 Deterred entry Deterrence under NMo is in this case more complicated than in the single-period setting With a large enough difference among the two periods, capacity is usually used in the low-demand period only. More expensive to deter (unused capacity) under Mo, as a consequence more accommodation Similar argument to that for the single-period case in this instance as well: Deterrence increases welfare if it requires a huge investment (i.e., for low values of the fixed cost).

49 Outline Definition and background Literature review The model one period Welfare results The model two periods Collusion Generalization Policy implications

50 Collusion under capacity constraints I Abundant literature on collusion relevant in this setting Collusion under capacity constraints: Davidson and Deneckere (1990) show that carrying excess (idle) capacity in a duopoly may end up favoring collusion, low capacity increases the Bertrand profit; in a Nash-reversion setting, after deviation, firms play Bertrand; hence with a low capacity the punishment after deviation is less severe, so that t the temptations t ti to deviate rise, and mantaining the cartel gets tougher; optimal strategy involves high (idle) capacity so as to collude

51 Collusion and MO Mo prevents the collusion-supportive strategy of high (idle) capacity installing In this case, collusion would be particularly damaging for welfare: not only, as it is standard, consumer welfare would decrease; but also, this kind of collusion would require a consistent investment in capacity, which would clearly reduce productive efficiency; in this sense, Mo is superior to NMo.

52 Outline Definition and background Literature review The model one period Welfare results The model two periods Collusion Generalization Policy implications

53 Financial transmission rights With minor modifications, our results could apply as well to other arrangements, such as: financial transmission rights; in FTR, the line owner has to auction the rights to use the line. Depending on the auction structure, the results could be exactly in line with a Mo arrangement; equivalent to a MO arrangement; although h it is crucially related to the auction format

54 Outline Definition and background Literature review The model one period Welfare results The model two periods Collusion Generalization Policy implications

55 Policy results I Conventional wisdom: pro-competitive effects of Mo rule on MTI (prevents capacity withholding). The model shows that under strategic investments and low r reduces entry possibilities; makes the incumbent more aggressive post-entry; increases both W and CS only if F is low; in a multi-period setting, reduces the incentives to invest in transmission capacity (as an investor cannot get his capacity remunerated in the low-demand periods).

56 Policy results II Mo reduces the collusive prospects Conclusions: relative desirability of Mo depends on the features of the market; a policy-maker should evaluate among other factors the fixed costs, the variable costs, the demand structure (the elasticity and the demand variations across different hours of the day/seasons of the year), the propensity to collude within the market

57 Maybe a policy proposal To reduce the undesirable effects of Mo in managing demand variations: policy makers could devise arrangements in the Mo applies only to specific hours or specific seasons of the year; so that I has no disincentives to calibrate its investment on the peak demand.

58 THANKS FOR YOUR PATIENCE!