Prepared by: Leigh Tesfatsion Date: 6 September 1999 For: Econ/Electricity Project Meeting, September 7 xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx NOTES ON "Market Power Issues in the Restructuring of the Electric Power Industry: An Experimental Investigation" by Jurgen Weiss, Harvard Business School xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx In this paper, results from a number of experiments with industry subjects conducted over the Internet illustrate the impact of seller concentration -- effects of increasing the number of sellers in different geographical areas, holding everything else the same (permits analysis of "local market power" pockets where consumer prices remain high despite decreases in seller concentration) demand side bidding -- active bidding or passive behavior transmission constraints -- limited transmission capacity, using a simple but realistic network of transmission lines connecting the various sources of demand and supply (permits effects of buyer and seller locational differences to be examined) two alternative pricing rules -- nodal pricing and uniform pricing on the nature of competition in a simulated market for electricity. The context of the experiments is a simulated electricity market in which the interaction between network constraints and market competitiveness is explicitly modelled. Previous work closest in spirit to this work: Cardell, Hitt, and Hogan (1997), Nasser (1997), and Borenstein et al. (1997). xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx TWO BASIC ISSUES: EFFICIENCY: Any gains in efficiency achieved by introducing the proper incentives for profit maximization through deregulation and privatization have to be weighed against the potential losses of efficiency resulting from the exercise of market power by the deregulated or privatized electric power companies. EQUITY: Even if electricity markets become more efficient overall, gains in efficiency may not benefit all market participants equally. xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx HYPOTHESES TESTED: Is an increase in the number of sellers likely to effectively curb any potential for market power exercise in deregulated electricity markets, and, if not, what other regulatory strategies are most likely going to be effective in mitigating any such market power? NOTE: Key aspects of market structure NB = number of buyers NS = number of sellers Size distribution of buyers Size distribution of sellers Weiss confounds concentration and capacity effects in his experiments, e.g., looks at cases with many small buyers and a few large buyers, so size and concentration are simultaneously changed. xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx KEY FINDINGS: As summarized on page 3, Weiss finds that simply increasing the number of sellers in a given geographic area may not effectively reduce market power. Rather, certain sellers maintain "local market power" and resulting consumer prices remain high. His experiments suggest an alternative strategy for reducing sellers' ability to exercise market power: he finds that experimental markets with countervailing market power by a few large buyers who are actively bidding for power were characterized by essentially competitive prices, even at high seller concentration. Weiss claims that this finding confirms previous findings by Bakerman, Denton, Rassenti and Smith (1997) and Borenstein and Bushnell (1997), who explored this issue in a simpler context. The current study's experiments involve a more realistic representation of a network for transmission of power which allows a number of additional issues to be addressed, and a more careful study of the relation between seller concentration and market power. Although the same findings are supported, Weiss claims (p. 5) they are supported for very different reasons as far as the impact of seller concentration on market power is concerned. The existence of congestion in the transmission system does not alter this result. Bottom Line: Active demand-side bidding by large buyers is a potentially important policy instrument in the process of rule making for liberalized electricity markets. Policy Implications: Investing in technology that leads to greater demand elasticity, and hence gives active wholesale buyers more bargaining power, may -- through the creation of countervailing market power on the demand side -- be at least as effective as investing in new generating capacity (i.e., reducing seller concentration) in terms of limiting sellers' ability to exercise market power. xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx MODELLING ASPECTS: (pp. 5 -->) Least Cost Dispatch, Nodal Spot Prices, and Uniform Prices ONE APPROACH TO LEAST COST DISPATCH: NODAL PRICING Centralized dispatch is assumed to solve the following welfare maximization problem: MAX Net Social Benefits NSB (Consumer + Producer Surplus) Subject to Network Balance Kirchoff's Law Constraints (e.g., when power is transported between two points of the transmission system, power will flow over all available "parallel paths" between those two points -- p. 4) Lagrangian Form: NSB + lambda*[network balance constraints] - mu*[Kirchoff's Law Constraints] AS LONG AS ALL MARKET PARTICIPANTS BEHAVE COMPETITIVELY -- i.e., take prices as given in determining their quantity demands and supplies, with no attempt to engage in strategic behavior with respect to any variable (e.g., congestion, capacity) -- least cost dispatch can be achieved with a system of prices called NODAL SPOT PRICES. A nodal price (i.e., price of electricity at a node) is the shadow value of power injection at the node. That is, it is given by the value of the Lagrange multiplier for the network balance constraint for that node in the least cost dispatch problem. Nodal spot prices can change instantaneously as a function of stochastic generation or transmission outages and stochastic weather-related demand changes, and that can differ by location. (Work by Schweppe et al.) SECOND APPROACH TO LEAST COST DISPATCH: UNIFORM PRICING The uniform price is determined by constructing a single pair of supply and demand curves from the bids and offers submitted, by ordering all bids in decreasing order and all offers in increasing order. The uniform price is determined by the intersection of the supply and demand curves and represents the bid made by the marginal generator. By construction, then, the uniform price does not vary by location, as do nodal prices. Also, it ignores any constraints imposed by the transmission system. Using the language of the English spot market for electricity, the uniform price is called the SMP (System Marginal Price). The pattern of load and generation, upon which the SMP is based, may not be feasible once transmission constraints are taken into account. Some agents who would buy or sell power in the unconstrained case must then be denied power -- they are called CONSTRAINED-OFF buyers or sellers. Other agents who would not be buying or selling power in the unconstrained case but who do so in the constrained case are called CONSTRAINED-ON buyers or sellers. In either case, a transfer payment is made FROM buyers TO constrained-on and constrained-off buyers and sellers so that they are indifferent between their output and purchases under either constrained or unconstrained dispatch. This transfer payment is a surcharge per unit of electricity bought and is called an UPLIFT PAYMENT. As a result of this mechanism, all costs associated with transmission constraints are averaged and born by the demand side, who pay the Pool Purchasing Price (PPP). It also means that the bids entered by the demand side represent bids for the SMP, and implicitly represent an agreement to pay whatever Uplift charges result from transmission constraints at the time of dispatch. It can be expected that demand side bidders will take into account likely uplift payments when making their bids. QUESTIONS: Are the uplift charges in the form of side payments (i.e., lump sum transfers rather than price adjustments)? How to choose just who gets constrained-on and constrained-off? Can the uplift payments feasibly be supported from within the dispatch system per se, are are fund injections from outside the system needed? What is the exact form of compensation to constrained-OFF agents? xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx SECTION 4: THEORIES OF MARKET POWER IN ELECTRICITY MARKETS (pp. 7 -->) Market Power = a seller's ability to profitably change her bidding behavior away from competitive bidding, resulting in higher market prices, reduced market efficiency, or a higher share of surplus captured by sellers. NOTE: This is at a pretty abstract level and confounds definition with implications. Also, the benchmark of comparison ("competitive bidding") may not be easy to quantify in any actual situation. 4.1 Seller Concentration and Market Power: Standard presumption: Inverse relation between seller concentration and market competitiveness Higher concentration <---> Higher prices, lower market efficiency Problems with this hypothesis: A. Seller concentration does not take into account any underlying demand or supply elasticities, both of which have an important impact on how much prices should rise as the number of firms in a market increases. B. Seller concentration indices does not capture the threat of potential entrants and the threat of additional regulations. C. The measurement of seller concentration is further complicated by the difficulty of determining the size of the relevant market. Depending on supply and demand conditions as well as on the state of the transmission system, the ability to supply power from one geographic area to another may be severely limited during certain times and easy during others, so that the size of the market depends on the degree of congestion of the transmission system which in turn depends on the actions taken by all firms in the market. In the context of uniform prices, there is no local market power as far as the determination of the SMP is concerned, since transmission constraints are ignored. However, local market power can be exercised by manipulating bids of plants, which are likely to be constrained-on or constrained-off in ways that increase uplift payments. KEY POINT: The likelihood of specific plants being constrained-on or constrained-off depends only on demand and the seller concentration AT THE NODE AT WHICH THE PLANT IS LOCATED, and is not reduced by an increase in the number of sellers located elsewhere in the network. Hence the ability to influence uplift payments may be independent of the overall number of players owning generating assets. 4.2 Demand Side Activity and Market Power There is little theoretical work in the industrial organization literature on the impact of demand side bidding on market prices. If the concentration of buyers is comparable to that of sellers, one would expect buyers to act strategically and thereby to extract a larger amount of social surplus than they would under passive demand-side bidding. Demand-side bidding by concentrated buyers is different from entry by new sellers (leading to lower seller concentration) in that, under certain circumstances, the incentives of both incumbent and entrant sellers may be aligned while those of buyers and sellers are always opposed. It can therefore be expected that active buyers will exert more competitive pressure on prices than entering sellers, at least under some circumstances. NOTE: This suggests the need to look at the numbers of buyers and sellers in absolute terms and not just the ratio of these two numbers. Two ways in which a small number of active buyers may force markets to be more competitive (p. 10): (1) presence of active rather than passive buyers introduces some uncertainty about actual levels of demand for sellers trying to decide on optimal bids, which may induce sellers to lower their bids relative to environments with no uncertainty in which a very large number of buyers make demand-revealing bids. (2) active buyers may force markets to be more competitive by strategically withholding demand, i.e., by underrevealing the true value of the demand they serve (thinking of large buyers as wholesale buyers representing a large number of individual consumers). This is suggested by experimental findings on ultimatum and dictator games that suggest buyers are willing to incur losses in one-period games if the proposed split of social surplus is perceived to be unfair. 4.3 Transmission Capacity and the Exercise of Market Power The existence of binding transmission constraints may increase the degree of market power for any given overall level of market concentration. It may be necessary to expand transmission capacity beyond the capacity suggested by engineering considerations in order to alleviate any existing local market power. 5. DESCRIPTION OF THE EXPERIMENTS (PP. 11 -->) Weiss claims his experiments differ from previous electricity market experiments in two important ways: (1) They include a more accurate representation of the electric transmission network -- the concept of nodal pricing as well as the concept of uplift can only be studied at the level of complexity studied here. (2) They make use of experienced industry subjects only, not students Buyers and sellers were located at different nodes of a simple network of transmission lines. Attention is limited to the case of no transmission losses and to active power only -- reactive power considerations are ignored. MY FIGURES 2-3 ARE NOT CLEAR -- DIFFICULT TO DETERMINE ACTUAL NETWORK SETUP Fixed generation capacity of 1300 MW distributed equally (??) among all sellers and located at 4 transmission nodes (a,b,c,d) connected through five (??) transmission lines. A competitive fringe owns 400 MW of capacity through four plants with 100 MW capacity each. The remaining 900 MW of capacity was equally distributed among all players (remaining sellers?). Transmission capacity of the lines connecting the four nodes was unlimited, except in the case of the line connecting nodes b and d. The transmission limit on that line was 100 MW during the first 23 rounds of the game and unlimited thereafter. The market was organized as a clearinghouse or call auction. In this institution, all bids and offers are posted simultaneously, and market prices are generally determined by the intersection of bid and offer arrays. No bilateral transactions between individual players are allowed. Call auction easier to implement via email than a continuous double auction, in which the timing of bids and offers is crucial. Playing over the Internet, bids and offers are subject to congestion delays. [This is one reason why earlier plans to include a continuous double auction mechanism in the California market have recently been abandoned.] In both pricing environments tested (nodal and uniform), an independent system operator (ISO) plays the role of the market clearinghouse and uses the bids provided to decide on the optimal pattern of load and generation. Unfortunately, this system may not be truth-revealing -- bids entered by market participants may not correspond to true underlying costs and demand values. All power plants in our experiments had constant variable costs over the entire range of output and had the same capacity. Plants A and E differed from other plants by a penalty incurred if they were not at least partially dispatched. This penalty was created to reflect the must-run character of many base-load plants in real electricity markets. QUESTION: What is a "base-load plant"? A substantial part of demand from the largest customer group was "must-serve" load. Not buying enough power to serve all must-serve load resulted in a severe penalty for buyers. Transmission system including four nodes permits loop flow effects to be studied, since there are several "parallel" paths for transporting power between any two points. Weiss claims his model is the first to permit loop flow effects to be systematically examined in lab setting. 5.3 SUBJECT POOL (p. 14 -->) The 180 participants in the experiments were recruited internationally via email advertisements to individuals associated with the electricity industry. [Participants told they could gain insights into the workings of competitive electricity markets and that they could win a prize of $2000.] Benefits: Electricity rules of the game difficult for students to comprehend, easier for actual market participants Danger: Market participants have vested interest in outcomes and could game the experiments to make outcomes support their own particular point of view 5.4 EXPERIMENT LOGISTICS (p. 16-->) Conducted over a twelve week period in 1997. A typical week consisted of 3 rounds. Overall, 33 rounds were completed, of which the first five were practice rounds. Each participant was randomly assigned to an experimental group and to a role within that group. Participants then received a detailed description of the game. All trading took place via email over the Internet. Each subject received feedback about his own performance after each round of play. Each player earned tickets to a lottery over a grand prize of $2000. Game profits --> lottery tickets 5.5 TREATMENT VARIABLES (pp. 17 -->) Four treatment variables Seller Concentration: Three levels -- one seller (monopoly), three sellers (triopoly), and six sellers. Demand Side Activity Level: Active or Passive Active --> wholesale buyers were actual players making bids to buy power Passive --> Demand side was simulated as fully demand revealing Pricing Algorithm: Nodal pricing and uniform pricing Transmission Constraints: Only imposed on one line, and only for the first 23 rounds of the game. Final ten rounds were played without the transmission constraint. The experimental Design is depicted in Table 2 (page 18). The design was not fully crossed. Only eight cells were played, with six observations in each cell. The choice of active cells was guided by a desire to test as many realistic mitigation strategies as possible. Therefore, an active demand side was only introduced for the three-seller environment. 6. MARKET POWER RESULTS (PP. 18-->) The market power analysis measures both efficiency and equity and considers both measures important indicators of market power. Market efficiency measure = deadweight loss (dwl) Market equity = share of social surplus captured by the sellers relative to the share captured in a competitive environment (relshare) = measure of market power Because the concept of price is different in nodal and uniform price environments, price cannot be used as a measure of market power whenever the two types of environments are directly compared. 6.3 GENERAL RESULTS (PP. 19-->) Tables 4--6 give regression results COMMENT BY MATT SMITH: Why not a panel data study in place of a regression study? (Panel data is data that separately tracks outcomes for specific individuals over time rather than averaging outcomes across agents.) FINDINGS FOR SELLER CONCENTRATION: (pp. 26--->) In all environments not including a monopoly seller, results during medium and low demand periods were insignificantly different from competitive outcomes. Consequently, Weiss limits his attention to the high demand period in all following analyses. In general, nodal prices tend to be lower the larger the number of sellers in the market. Monopoly prices are higher than tripoly prices which in turn tend to be higher than six-seller environment prices. There are, however, some interesting differences across nodes with respect to how prices change as the number of sellers is increased that tend to support the hypothesis regarding the relation between prices and local market power strengths. Results are similar for uniform price environments -- the SMP drops consistently as the number of sellers is increased. Also, the magnitude of the uplift does not change dramatically as the number of sellers is increased. It is not easy from the graphs to see any consistent pattern in deadweight loss across experiments. Therefore, relshare may be a better indicator of market power than the efficiency measures in the context of this experimental design. The portion of social surplus captured by producers is highest for monopoly environments, followed by three-seller environments. Six-seller environments and environments with active demand side bidding tend to exhibit the lowest producer shares, hence tend to be closest to the competitive outcome. OVERALL CONCLUSIONS: Some support for the traditional view of the relationship between seller concentration and the exercise of market power. Market power does tend to decrease as the number of sellers is increased, but there may be important local market power leading to persistently high prices at some locations or to persistently high uplifts in uniform price environments. The regression results confirm the graphical analysis. While both nodal and uniform price environments show evidence of the exercise of local market power, the nature of local market power differs between the two environments. In nodal price environments, only players with plants that are likely to be constrained-on have local market power. In uniform price environments, both players with constrained-on and with constrained-off plants can exercise market power by manipulating their offers for plants which are likely to be either constrained-on or constrained-off. As a result, profits in nodal price environments are concentrated in the hands of those players who own constrained-on plants. They are distributed more evenly in uniform price environments. FINDINGS FOR DEMAND-SIDE ACTIVITY: (pp. 30--->) Active demand-side bidding significantly lowers market power for a given number of sellers and therefore promises to be an excellent market power mitigation strategy. It is successful in removing any local market power found in nodal price environments... It also significantly lowers the SMP in uniform price environments, but has no impact on the magnitude of the uplift. It appears that a large portion of the significant reduction in market power with active demand-side idding can be attributed to the fact that in those environments sellers face increased uncertainty about actual levels of demand... However, we also observe that more than half of the actively bidding buyers in our experiments act strategically, and aggressively try to lower market prices. This in turn further reduces the extent of market power exercise by sellers. This second benefit of active demand-side bidding by a small number of buyers is unlikely going to be achieved without the creation of bilateral markets in which buyers are allowed to concentrate to levels comparable to sellers. 6.6 FINDINGS REGARDING TRANSMISSION CAPACITY (PP. 33-->) Results strongly support hypothesis 4: when the transmission constraint is binding, which is most often the case during high demand periods, certain producers are effectively excluded from competing with their entire capacity, thus reducing the amount of overall capacity available to meet demand and hence increasing the effective market share of those sellers not excluded through an existing transmission constraint. Sellers in the experiments were able to exploit this situation successfully. 7 OVERALL SUMMARY (PP. 34-->) Standard solution for decreasing market power -- an increase in the number of sellers competing in the total market -- may not be sufficient to lower prices at all market locations if transmission capacity is limited and under certain demand conditions. While an expansion of the transmission system will remove such local market power, we find that demand side bidding may be an equally powerful market power mitigation strategy, in particular in a system of nodal prices. The pricing mechanism has important implications for the distribution of rents among buyers and sellers as well as for the sources and remedies of market power. Under nodal pricing, the profits accruing to buyers and sellers in the market will differ substantially across the newtork, even when the underlying cost structure of plants and resale values of demand are identical. On the other hand, these differences are an indicator of where the value of electricity is high and where it is low, and can thus guide decisions for either entry of new or decommisssioning of existing generation facilities. With respect to high nodal prices at some locations, an effective mechanism for lowering them is active bidding power by a small number of buyers on the demand side of the market. Therefore, policy measures aimed both at increasing demand elasticity through technology and aiming at increasing the bargaining power of the demand side by allowing active participation of concentrated intermediate buyers may provide promising means of making the resulting markets more competitive. Uniform prices as used in the British spot market for electricity have their own set of problems, most of which are confirmed by our experiments. Strategic use of uplift. The total amount of rents extracted from consumers via uplift payments in uniform price environments is not substantially reduced as market concentration is lowered due to the influence of transmission constraints. In conclusion, it appears that both nodal and uniform pricing rules create similarly strong incentives to exercise local market power and that this local market power is not easily mitigated by increasing the number of sellers in the market. Split of profits more uneven under nodal pricing. But nodal pricing provides correct signals for entry and exit in the long run and correct price signals for equating short run marginal costs and benefits. Also, active bidding by a small number of buyers as a means of reducing seller market power is more effective in nodal spot pricing environments than in uniform pricing environments. Therefore, nodal pricing may be the preferable alternative over a system of uniform pricing.