Lessons Learned from Market Monitoring in North American Electricity Markets

Transcription

1 Lessons Learned from Market Monitoring in North American Electricity Markets Presented at: World Bank Electricity Forum David B. Patton, Ph.D. Potomac Economics February 24, 2003

2 The Importance of Market Monitoring Deregulation is premised on the benefits of replacing price regulation with competitive forces to guide generation and transmission usage and investment decisions. Given the benefits promised by competition, the U.S. has adopted a policy of deregulating the wholesale markets relying on market monitoring and mitigation to address potential market power concerns. This policy approach is appropriate for the U.S. due to the strength of the transmission infrastructure and the number competing suppliers in most areas. Relying exclusively on market monitoring and mitigation to ensure newly-formed electricity markets function competitively and efficiently may not be appropriate for other countries. A structural assessment prior to implementation of competitive markets m is in most countries would be advisable.

3 The Focus of Market Monitoring Consistent with the Commission s s SMD requirements, the Market Monitor identifies: Flaws in market rules that create inefficiencies or gaming opportunities; Efficiency improvements; Market power abuses; The first lesson learned is that the findings from market monitoring with the largest economic value have been related to improving market rules and procedures, not related to market power. Market efficiency and market power generally receive equal monitoring oring attention contrary to the assumption of most that market power is the primary focus.

4 Independence of Market Monitoring Independence of the Market Monitor from the RTO is becoming more important due largely to its role in monitoring the RTO s operations. This independence has been achieved by making a portion or all of the market monitoring final function external to RTO. The current markets in the U.S. utilize a monitoring structure composed c of an internal unit and an external Advisor/Committee (except PJM, with only an internal unit). The developing RTOs in the U.S. are generally moving toward independent external monitoring. To ensure the independence of the monitoring function, the market monitor reports to both the independent Board of Directors of the e RTO and the Federal Energy Regulatory Commission ( FERC( FERC ).

5 Role of Market Monitoring in Improving Market Performance The market flaws and efficiency improvements to be identified include: Distorted Market Outcomes.. Modeling procedures, system operations, and pricing rules can lead to inefficient prices and outcomes, even e when participants behave competitively. Inefficient Conduct. The market rules may impose unintended costs/risks on participants that cause their conduct to depart from competitive ive expectations. Strategic Conduct.. Flaws in the market rules can create opportunities for participants to profit by departing from competitive conduct. It may be difficult to differentiate inefficient or strategic conduct from market power however, this is critical since the preferred response is to remedy the market flaw and restore efficient incentives.

6 What is Market Power and When is it a Problem? Market power is the ability of a firm to profitably raise the price of a product; Market power exists in nearly every product market, the most of which are not regulated -- only perfectly competitive markets exhibit no market power; Market power is not always bad -- Market power provides incentives for firms to innovate and is the basis for the patent laws; In general, it is far more costly to eliminate all market power than to allow the some market power to exist. For this reason, perfect competition is not the appropriate standard economist generally refer to workable competition as a competitive tive standard with an acceptable level of market power. References to market power by economists and policymakers generally pertain to unacceptable levels of market power.

7 When is Market Power a Problem? Is market power necessary to provide proper incentives for new investment? No. Prices affected by substantial market power provide misleading price p signals to both generation and transmission investors. Investment that is motivated only by market power (scarcity prices resulting from withholding) is inefficient. Further, if investors suspect that supply is not truly scarce and d understand that their entry will mitigate the market power, they will not enter e in response to these prices. Significant abuses of market power in the spot market, despite typically t representing a small share of all market transactions, will affect buyers and sellers in all markets futures prices are based on spot prices.

8 Nature of Market Power in Electric Markets Market power in electric markets is generally caused by one of two t factors: Transmission constraints that create locational market power. Peak demand conditions. Locational Market Power Transmission constraints can create isolated geographic markets subject to substantial market power -- must-run units are an extreme example. Such constraints may occur naturally or by manipulation of transmission facilities or generator dispatch patterns. Every operating ISO has some form of real-time mitigation to address this form of market power

9 Nature of Market Power in Electric Markets Peak Demand Market power can exist under peak demand conditions in a market area with many apparent competitors. A large supplier can become a monopoly over a portion of the demand when competitors resources are operating at full output with no ability to respond to withholding by the supplier. Market power is enhanced by the fact that current electric markets lack meaningful demand participation. These two conditions are generally transitory -- thus, mitigation to limit abuses of market power during a small number of hours to allow unfettered market-based pricing in all other hours is appropriate.

10 What Conduct May Indicate an Attempt to Exercise Market Power? Price fluctuations are not the primary indicator. The key to differentiating between market power and scarcity is to determine whether resources are being withheld from the market: Physical withholding withdrawing or derating an economic unit. Economic withholding raising a generator bid so as not to run or raise the clearing price. Focusing on withholding from the spot market is the appropriate focus for monitoring since the spot market will discipline the forward markets. Other forms of strategic conduct include: Creating congestion through a) outages of transmission; b) understating transmission ratings/capacity; or c) uneconomic dispatch of generation. Conduct by utilities or transmission owners to depress prices (e.g., unjustified out-of of-merit dispatch).

11 Identifying Economic Withholding Economist generally agree that when suppliers are paid a market clearing price in an RTO market, a competitive bid would be at marginal costs c often approximated using variable costs. Variable costs can be useful for comparison purposes, but are problematic as the primary measure for identifying economic withholding. The process of receiving and auditing variable cost information for generating units can be intrusive and cumbersome. Variable costs are not a good proxy for marginal costs for a considerable amount of resources emergency output, units with substantial opportunity costs (e.g., hydro resources, units with environmental restrictions, etc.) Using accepted bids during past competitive periods as a benchmark for assessing current bids is a reasonable alternative known as reference prices in a number of U.S. markets.

12 Measuring Market Power Some economists have performed studies that attempt to measure the t extent of market power by comparing actual prices to simulated prices under u assumed perfect competition. These studies tend to overstate the effects of market power on prices p for the following reasons. The simulations generally assume variable costs equal marginal costs c for all resources, which fails to recognize the full marginal costs for the highest- cost output segments in the market. The simulations often do not account for normal deratings, causing supply in the simulation to be overstated and the simulated prices to be b understated. The unit commitment decision and the generators physical parameters (ramp rates) are generally not included in the simulations, which h results effectively increases the assumed supply and lowers the simulated d prices.

13 Real-Time Market Monitoring The economic and physical withholding screens are used to identify conduct that may warrant further investigation on an hourly basis. s. Economic withholding screen: A generator raises its bid prices substantially (>$100 per MWh in New York). Physical withholding screens: A large quantity of resources that t should be available are not dispatched or offered to the market. In most cases, the bids can be adequately justified by the supplier; In nearly all cases, the withholding has very little effect on prices and is, therefore, not an abuse of market power (i.e., one may presume that t the conduct related to other factors). This daily monitoring using the reference prices is complemented by a longer-term analysis of bidding patterns to determine whether the New York markets are workably competitive under most conditions.

14 Competitive Analysis of Bid Patterns The longer-term analysis assesses potential withholding relative to factors that can create market power. First, suppliers in a competitive market should have an incentive e to aggressively offer their resources, regardless of size. Therefore, there should be no correlation between participant size and the amount of capacity economically withheld or physically derated. Second, suppliers in a competitive market should increase bid amounts during higher load periods to sell more power at the higher peak prices, while those in markets that are not workably competitive will offer fer less at peak load levels when the market impact is the largest. Therefore, the correlation of withholding behavior to load levels s should be analyzed. The following charts show examples of these results from New York.

15 Relationship of Actual Load to Offers Exceeding Economic Withholding Thresholds Day-Ahead Market -- East New York January 1 to December 31, pm Hour 2,500 Offers Above Threshold (MW) 2,000 1,500 1, ,000 10,000 12,000 14,000 16,000 18,000 20,000 22,000 Actual Load (MW)

16 6,000 Relationship of Deratings to Actual Load Day-Ahead Market -- East New York Summer Peak Hours * Derated Capacity (MW) 5,000 4,000 3,000 2,000 12,000 14,000 16,000 18,000 20,000 22,000 Actual Load (MW)

17 Analysis of Efficient Trading In addition to the assessment of competitive conditions, an analysis of whether efficient trading is facilitated by the RTO is a critical component of overall market performance. Two types of arbitrage analyses are relevant: Analysis of the convergence of spot and forward energy prices (intertemporal arbitrage); Analysis of the convergence of prices in the RTO and neighboring markets (geographic arbitrage). Poor performance in either area will result in inefficient prices, higher overall market costs, and larger risks for participants.

18 Mitigating Market Power The first and best form of mitigation is to address the structural characteristics of the market: Promoting transmission investments to reduce congestion and associated locational market power; Remove barriers to investment in new generation; Facilitating demand-side participation in the market; and Divestiture reducing concentration of supply ownership.

19 Mitigating Market Power Even with the structural mitigation, market power concerns may still s justify behavioral mitigation. Behavior mitigation includes measures that restricts a supplier from exercising market power. In developing behavioral mitigation measures, policymakers should adhere to the following principles: The measures should not affect participants bidding competitively including causing suppliers to bid or generate below their marginal cost; Mitigation should not artificially limit price movements particularly during times of shortage; and If possible, mitigation should be applied prospectively.

20 Locational Bid Cap The locational bid cap mitigates economic withholding that would be used to exercise market power in a constrained area: The caps are set at a competitive reference price for each unit; Abuse of market power should exist before the cap is employed: 1. A generator raises its bid substantially (>$100 per MWh); and 2. The generator s conduct causes prices to rise significantly. The combination of the conduct and impact tests seeks to minimize unwarranted intervention by the RTO by requiring substantial evidence of an abuse of market power prior to mitigation. Other forms of locational bid caps would trigger only on the presence of congestion, which may not be a reliable indicator of market power.

21 Characteristics of the Bid Cap The unit that was mitigated still receives the market clearing price p it is not intended to be punitive. Mitigation should not impact scarcity pricing as long as (1) high-cost resource segments have appropriately determined reference prices and (2) price are set by demand or at the safety-net bid cap when the system is in shortage. Mitigation do not constrain prices from being efficiently arbitraged aged with prices neighboring markets. Requiring that both the conduct and impact thresholds be exceeded d has limited the mitigation to a very small number of occurrences. The primary drawback of this approach is the time required to implement mitigation is being addressed by a partial automation of the process.

22 David B. Patton, Ph.D. Phone: Potomac Economics David B. Patton is the President of Potomac Economics, which specializes in economic consulting to clients in the electricity and natural gas industries. ies. Potomac Economics has been engaged by the Midwest ISO and Southwest Power Pool to be their t Independent Market Monitor, responsible for identifying and remedy flaws in the market design or attempts to exercise market power. He also serves as the Market Advisor for the New York ISO and ISO New England. In addition to monitoring electricity markets, Dr. Patton provides strategic advice, analysis and expert testimony on deregulation, transmission pricing, asset t valuation, market design, and competitive issues. He has provided expert testimony or analysis in a number of horizontal and vertical utility mergers, antitrust cases, wholesale market design matters, and rate proceedings before the FERC, state regulatory agencies, the Department of Justice, and the Federal Trade Commission. Prior to consulting, Dr. Patton served in the Office of Economic Policy at the FERC where he advised the Commission on policy issues ranging from transmission n pricing and open access to mergers and market power. He has published and spoken on a broad b array of topics related to emerging competitive electric markets, including transmission congestion and pricing, risk management and market power.