Market Power in Electricity Markets

Over the last few years, I’ve gotten very interested in issues surrounding the incorporation of renewable energy into IT and, more generally, the smart grid.  One of the issues that has particularly grabbed my attention is that of “market power.”

Now, market power is typically one of those fuzzy concepts that academics like to ignore — often with a phrase such as “we assume that agents are price-takers.” I’ve done this plenty of times myself, and often, this is an okay way to get insight about a problem.  But, as I’ve gotten involved in electricity markets, it has become more and more clear that you can’t get away with ignoring market power issues in this context.

Unfortunately, quantifying (and even defining) market power is a tricky thing — and if done badly, it can lead to damaging regulatory problems.  But, on the other hand, if it is ignored, the problems can be equally bad.

So, we’ve set out on a number of projects recently that are trying to bring some rigor to this area…  In fact, we recently received an NSF grant on the topic — thank you EPAS!

I’ll probably write more posts in the future on specific projects that we’re working on, but I wanted to use this post just to bring some attention to the general issues in the area.  Note that much of this discussion is adapted from a recent article we (Subhonmesh Bose, Chenye Wu, Hamed Mohsenian-Rad, and myself) wrote for the IEEE Smart Grid Newsletter.  You can find the full article here.

Deregulation and market power

Until the 1990s, electricity had been supplied in the United States by regulated utilities, each with a franchise service area in which it had the right to sell and was allowed a mandated level of profit. Since the 1990s, however, electricity markets in many regions have moved to a more deregulated structure, where the prices are set through mechanisms such as bidding. The intention of this shift was to encourage innovation and competition in technology, while also bringing power prices down. But, as is often the case, the process of deregulation was quite bumpy.  In particular, in some deregulated and restructured power systems, prices have instead spiked sharply higher and, in some notorious cases, market manipulation was found to be at the root of the spikes.

The California electricity crisis that ushered in the new century remains the most notable case in point: it involved frequent blackouts, and an 800-percent increase in wholesale prices from April to December 2000. Investigations led by the Federal Energy Regulatory Commission (FERC) revealed that on multiple occasions, though installed generation capacity was significantly greater than total load demand, some energy companies managed to rig markets to create artificial shortages, which led to price peaks.

Because of that ability on the part of energy companies to manipulate markets to their advantage—because of their market power —California ratepayers ended up spending about $5.5 billion more for electricity from 1998 to 2000 than they otherwise would have. The practical importance of identifying such market power and preventing its exercise is obvious.

Defining market power

Examples like the above highlight that identifying the potential for and exercise of market power is important; however, before doing that, one must define market power — which is a difficult task in its own right.

The U.S. Department of Justice defines market power as the ability of a supply firm to profitably alter prices away from competitive levels. Market power is thus connected with a form of market dominance, where a supplier has the ability to behave independently of competitors and consumers in a manner that increases its profitability.

In practice, defining market power in electricity markets is challenging, and requires more clearly specifying two of the terms in the previous paragraph: “alter prices” and “competitive levels.” Typically, the notion of “altering prices” has a component of both magnitude and duration, such as altering the price of electricity by 15 percent over ten days during a year. As for “competitive levels,” it can be hard to distinguish naturally high competitive prices from prices that are the result of market power.

Furthermore, identification of market power requires ensuring that the manipulation was profitable and intentional. Verifying these two components can be delicate; determining profitability requires knowledge of the complete portfolio position of a company, and intentional withholding of electricity to generate shortages can be hard to distinguish from real breakdowns that just happen to be profitable.

Further complications arise from the geographic scale in which market power might be exercised. Such dominance can be gained throughout a wholesale power pool, for example, by a power supplier with a large enough generation capacity; or in just one segment of a power pool, say by a power supplier in a region that has limited ability to import less expensive electricity.

Market power measurements today

Unfortunately, because of the issues above, the measures used in practice today are mostly ad hoc and derived largely from economic measures for generic (non-electricity) markets. In recent years, however, systematic design of market power measures has begun to emerge based on both long-term and short-term analysis. Long-term approaches most often study the potential for market power; that is to say, they are usually ex-ante. They are useful for tasks such as market design evaluation, merger analysis, and operation planning, as well as for identifying “must-run” generators in advance. Short-term approaches, in contrast, study the exploitation of market power; that is, they are usually ex-post. They are typically applied close to the spot market, and focus on things such as immediately mitigating market misconduct via penalties for withholding generation.

Given the fractured nature of the literature on market power, there is currently a great need to put market power analysis on a firmer foundation, one that connects short-term and long-term perspectives and takes into account both economic fundamentals and the physical characteristics of transmission systems. The need for such new market power measures will become even more pronounced in the coming years, as we move toward a smart grid that includes high penetration of renewable energy, distributed generation, energy storage and increased use of demand-response programs. While offering more flexibility, each of these emerging components of the smart grid paradigm mentioned above are expected to have impact on both long-term and short-term market power analysis.

This is exactly the goal of the research that we are pursuing… We’ve published one paper in this direction so far,  A unified approach to quantifying market power in the future smart grid, but much more work is needed, and I’ll be very happy to hear perspectives on the topic from others in the area.

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One thought on “Market Power in Electricity Markets

  1. Pingback: Rigor + Relevance | Report from SoCal NEGT

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