On the Exercise of Market Power Through Strategic Withholding in California
AbstractBeginning in June of 2000, the shock of unexpectedly high prices in the California electricity market convinced everyone of the need for policies to correct the apparent market failures. The public debate and policy discussions have been dominated by a focus on market power as a principal problem amenable to regulatory solution. However, design of effective policies to moderate prices or mitigate their effects depends on the diagnosis of the underlying causes. High prices attributable largely to an exercise of market power in electric generation would point to particular market participants and behaviors that could be targeted for regulatory action. By contrast, high prices attributable to bad electricity market design would indicate a need for changes in the design. High prices attributable to higher fuel prices, environmental constraints and capacity shortages, on the other hand, would prompt actions to address the cost of fuel and environmental limitations and indicate that retail loads should receive the appropriate price signal for conservation. Suppliers could affect market prices by strategically withholding some capacity in order to profit on the capacity actually sold in the market. But charging high prices during periods of scarcity is not classified as exercising market power if there is no strategic withholding of supply. Likewise, refusing to supply without being paid is not an exercise of market power. Although the potential for withholding exists for many suppliers, the focus of attention has been on the exercise of market power by thermal generators in California. On its face, the experience of extremely high prices suggests that the exercise of market power could be important. But at the same time the data show that there have been profound changes in the California market such that the thermal generators have actually increased their production more than demand has grown. If anything, thermal generators that hit annual output limits produced too much rather than too little in the summer of 2000. Furthermore, the widespread impacts of higher electricity prices throughout the western market, both on and off peak, indicate that if the exercise of market power is important it is occurring to an extent and through channels unprecedented in this or other electricity markets. In short, this is a complicated story, and there is ample room for further investigation of the data and diagnosis of causes. Examination of the major analyses of the exercise of market power reveals that the estimated magnitude of the possible strategic withholding of electric generation is small enough to make it important to verify the simplifying assumptions. If strategic withholding were large and pervasive, then the real details of the California electricity market could be ignored. But it is by now apparent that the evidence is not clear, and any finding of the presence or absence of strategic withholding of generation in the California electricity market could turn on the simplifying assumptions used in the analysis of the data. For example, annual limits on production dictate that plants should not run in many hours when prices are higher than direct incremental costs; hence, examinations of output decisions for individual hours or months are necessarily incomplete. The variation in real time conditions is large enough to produce significant reductions in output compared to the expectations given day-ahead prices; hence, with capacity constraints average optimal production is necessarily less than optimal production at average prices. Limits on the ramping rate of generation units, start-up costs, minimum load costs and other operational inflexibilities imply that a dispatch day is not just twenty-four separate hours and must be analyzed chronologically, recognizing these factors. And so on. Accounting for such effects can reverse the implications of the previous evidence. Unfortunately, the real details are neither simple nor incidental. It is difficult to conduct a study of market power based solely on publicly available data. A fuller analysis would require data available only to the California Independent System Operator, and has not been done. Many factors contributed to higher electricity prices in California, and the market power theme is only, at most, part of the story. The import of the previous analyses is not to prove that market power has been exercised in the California electricity market but, rather, to suggest that it might be important. The import of the sensitivity analysis here is not to prove that market power has not been exercised in the electricity market but, rather, to suggest that it is unlikely to be the dominant factor and may not even be significant. With the available data in the public domain, and the special complications introduced by the California market design, the margin of error in estimating the extent of the possible exercise of market power through strategic wit hholding of electric generat ion is of the same order of magnitude as the effect being measured. On balance, to date the publicly available data provides no reason for the Federal Energy Regulatory Commission to change its conclusion that there is no evidence of strategic withholding nor any proof that no strategic withholding has occurred. By contrast, there is general agreement that the California electricity market design is "seriously flawed." Furthermore, there is evidence that the policy responses that have been adopted in California have accelerated an already serious market collapse. Hence, without dismissing the possibility of the exercise of market power, the principal policy focus should be on fashioning workable solutions for the other more serious problems in market design that relate to the underlying causes of the market meltdown. Separate from market power mitigation, California should pay its bills, raise incremental prices to retail customers, and move as quickly as possible to operating a coordinated and efficient market with consistent pricing for all that includes unit commitment, day-ahead scheduling, and real-time balancing. Although not a panacea, these steps would address immediate problems and set the stage for longer-term initiatives to expand generation capacity, transmission infrastructure and the reach of an efficient market to the western interconnected grid.
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Date of creation: May 2001
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