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Arbitrage in Energy Markets: Competing in the Incumbent’s Shadow

  • Kupper Gerd


    (K.U.Leuven-Center for Economic Studies)

  • Willems Bert


    (Tilburg University, TILEC and K.U.Leuven-Center for Economic Studies)

This paper studies the welfare implications of using market mechanisms to allocate transmission capacity in recently liberalized electricity markets. It questions whether access to this essential facility should be traded on a market, or whether the incumbent should retain exclusive usage rights. We show that granting exclusive use to the incumbent might be optimal, if the capacity of the essential facility is small and the incumbent can reduce production costs by taking advantage of interregional production-cost di?erences. This result counters the intuition that arbitrage will improve the social surplus when there is no output contraction. The reason is that when competition is imperfect, arbitrage might reduce production e?ciency. We advise policymakers to introduce market mechanisms for the allocation of transmission capacity only if su?cient investment in the network is ensured or if the market power of the incumbent is broken in at least one of the markets in which it is active.

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Paper provided by Katholieke Universiteit Leuven, Centrum voor Economische Studiën, Energy, Transport and Environment in its series Energy, Transport and Environment Working Papers Series with number ete0707.

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Length: 48 pages
Date of creation: Nov 2007
Date of revision:
Handle: RePEc:ete:etewps:ete0707
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  1. Bert Willems, 2002. "Barring consumers from the electricity network might improve welfare," Energy, Transport and Environment Working Papers Series ete0213, Katholieke Universiteit Leuven, Centrum voor Economische Studiën, Energy, Transport and Environment.
  2. Malueg, David A, 1993. "Bounding the Welfare Effects of Third-Degree Price Discrimination," American Economic Review, American Economic Association, vol. 83(4), pages 1011-21, September.
  3. Joskow, Paul L & Tirole, Jean, 1999. "Transmission Rights and Market Power on Electric Power Networks I: Financial Rights," CEPR Discussion Papers 2093, C.E.P.R. Discussion Papers.
  4. Reza Ahmadi & B. Rachel Yang, 2000. "Parallel Imports: Challenges from Unauthorized Distribution Channels," Marketing Science, INFORMS, vol. 19(3), pages 279-294, March.
  5. Severin Borenstein & James Bushnell & Steven Stoft, 1997. "The Competitive Effects of Transmission Capacity in a Deregulated Electricity Industry," NBER Working Papers 6293, National Bureau of Economic Research, Inc.
  6. Richard Gilbert & Neuhoff, K. & Newbery, D., 2002. "Allocating Transmission to Mitigate Market Power in Electricity Networks," Cambridge Working Papers in Economics 0225, Faculty of Economics, University of Cambridge.
  7. Layson, Stephen, 1988. "Third-Degree Price Discrimination, Welfare and Profits: A Geometrical Analysis," American Economic Review, American Economic Association, vol. 78(5), pages 1131-32, December.
  8. Varian, Hal R, 1985. "Price Discrimination and Social Welfare," American Economic Review, American Economic Association, vol. 75(4), pages 870-75, September.
  9. Shih, Jun-ji & Mai, Chao-cheng & Liu, Jung-chao, 1988. "A General Analysis of the Output Effect under Third-Degree Price Discrimination," Economic Journal, Royal Economic Society, vol. 98(389), pages 149-58, March.
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