Regulating Monopolies in a Small Economy

Lessons for the New Zealand Electricity Supply Industry

Frank A. WolakDirector, Program on Energy and Sustainable Development

Professor, Department of Economics Stanford University

Stanford, CA 94305-6072wolak@zia.stanford.edu

http://www.stanford.edu/~wolak

1

Motivation for Lecture• Sentiment has been expressed that New Zealand may

not able to afford expense of competition law regulator– “Light-handed regulation” is a uniquely New Zealand

concept– Instead rely on self-policing actions of market participants,

not mandates or enforcement actions of regulator

"The unfortunate truth may simply be that competition law is a luxury that some governments can no longer afford.“

Grant David (Telecom's lawyer):http://www.chapmantripp.com/news/Pages/Do-we-still-need-a-Commerce-Commission.aspx

2

Purpose of Lecture• Explain why New Zealand cannot afford do without

a best-practice regulator for electricity sector– Regulate price and terms of service for monopoly

segments of industry– Monitor industry and regulate rules for segments where

market mechanisms are used to set prices

• Why effective regulatory oversight is essential to achieving a restructured electricity supply industry that benefits consumers– Why challenge in New Zealand is particularly great

• Describe features of best-practice regulatory process that could be implemented in New Zealand

3

Outline of Lecture• What is Electricity Industry Re-structuring?

– Alternative solution to traditional market design problem for electricity supply• Market Design Problem

– Generic market design problem– Necessity of explicit market design process in electricity industry

• Two major dimensions of regulatory oversight– Regulating monopoly segments of industry– Regulating rules governing market-based segments of industry

• Goal of market design process in wholesale market regime• Challenges that make achieving success in New Zealand even more difficult

– Vertical Integration– Hydro-dominated system– Transmission network configuration

• Best Practice Features for New Zealand Regulatory Process– Price regulation for monopoly segment to enhance competition in market segments– Market monitoring and rules regulation to enhance competition in market segments

4

Restructuring not Deregulation• Replace explicit regulation with market mechanisms

to set prices for some, but not all, industry segments– Price-regulated open access to

• Transmission network• Local distribution network

• Market mechanism to set prices for wholesale power and determine which generation units produce energy

• Market mechanism to set prices for retail electricity and determine which retailers sell electricity to final consumers

5

Regulation Always Necessary• Technology/economics of delivering electricity implies

– Only one transmission and distribution grid for a given geographic area

• Large fixed cost to construct network• Close to zero marginal cost to operate

• In all regimes, monopoly supplier of transmission and distribution services for each geographic area requires strict regulatory oversight of prices– Unregulated monopoly can set prices for use of network that

extracts all monopoly profits from electricity supply

• How these segments are regulated can have large impact on benefits consumers receive from restructuring

6

Why Market Design Is Necessary• How can restructured regime yield benefits to consumers

relative to vertically-integrated regulated monopoly regime?– Need theory of market design to start to answer this question

• Market Design – Set number and size of market participants – Set rules for determining revenues each entity receives– So that combined actions of each participant acting in its

own best interest yields market outcomes as close as possible to market designer’s desired outcome

• Many feasible market designs, each of which can yield different market outcomes– Vertically-integrated regulated utility most common historically

7

Market Design Challenge• Major challenge of market design process

– Once market rules are put in place all market participants will optimize against them• Generation unit owners, transmission network owners, distribution

network owners, retailers

– Market participants will push envelope of market rules

• Must analyze strategic implications of all market rules– Anticipate how participants will use market rules to

maximize their expected profits• Exploit private information they possess

– Use principal-agent theory to understand strategic implications

8

Principal/Agent Problem• Examples—client/lawyer, patient/doctor, firm

owner/firm manager, and regulator/firm– One familiar to everyone here—Parent/child

• Principal faces an asymmetric information problem– Typically does not observe everything that agent does

about its economic environment– Principal’s payoff depends on agent’s actions

• Other factors impact principal’s payoff– Agent’s payoff depends on its own actions, method used

by principal to compensate agent, and other factors• Principal designs mechanism for compensating

agent based on observable variables that causes agent to take actions desired by principal

9

Theory of Market Design

• Market Design involves Principal/Agent problems at multiple levels

• First level—Regulator/Firm– Principal = Market Designer

• Usually government and/or regulator– Agents = Firms and consumers in market

• Second level—Firm Owner/Firm Manager– Principal = Owner of Firm– Agent = Management of Firm

10

Optimal Market Design • Proposed objective function for market

designer– Lowest annual average retail price of electricity

consistent with long-term financial viability of industry

– In economist’s language--maximize consumer surplus subject to marginal firm in industry earning zero economic profit

• Both vertically-integrated and wholesale market regimes have access to same technology• Differences in outcomes is explained by market

participants facing different incentives about how to use it

11

Necessity of Market Design • Most markets do not require explicit market design

process– Locations where economic agents trade

• Formation of New York Stock Exchange (NYSE)• Evolution of retail coffee beverage market

• Economic agents are free to trade at any market they like– Buyers search for markets offering lowest selling price– Sellers search for markets that offer highest buying price

• Why do network industries, particularly electricity, require explicit market design process?

12

Necessity of Market Design • Physical network required to deliver electricity

– Despite Nikola Tesla’s attempts, cannot beam electricity to final customers

– Consumers and producers cannot switch physical networks to buy from or sell from to find one they like best

– Economics and politics implies a single transmission and distribution network for single geographic area

• This requires designing a regulatory mechanism for planning, building, and operating network– To ensure equal access to networks for all market participant– To compensate entities that manages transmission and distribution

networks– To set prices charged for use of transmission and distribution networks

13

Market Design Challenges for Wholesale Market Regime

14

Major Market Design Challenge with Privately-Owned Firms: Market Power

• Electricity supply industry extremely susceptible to the exercise of market power in the spot market– Demand must equal supply at every instance of time at every location in

the transmission network– All electricity must be delivered through transmission network– Non-storability of product

• Demand varies throughout the day– Production subject to severe capacity constraints– How electricity is priced to final consumers makes real-time demand

elasticity effectively equal to zero• Implication--Firms can exercise enormous amounts of market

power in a very short period of time

15

Market Design Challenge with Regulated Firms: Productive Efficiency

• How to cause producers to supply electricity in technically and allocatively efficient manner– Technically efficiency = produce the maximum amount of output for a

given quantity of inputs—capital, labor, input energy, and materials– Allocative efficiency = produce fixed amount of output at least cost

given input prices

• Setting prices to recover incurred cost of production does not provide incentives for technically or allocatively efficient production– Firm maximize expected profits subject to regulatory process used to set

prices may not lead to least cost production• Wolak (1994) “An Econometic Analysis of the Asymmetric Information, Regulator-

Utility Interaction,” available on web-site.

16

Regulated versus Market Pricing• Restructured regime restricts regulated portion of industry to

smallest entity possible– Transmission and distribution are only regulated services– Generation and electricity retailing are open to competition

• Traditional regulated regime imposes regulatory process on all aspects of industry– Final output price of vertically-integrated monopoly is regulated

• Choice between regulation and competition depends which regime comes closer to achieving market design goals for each stage of production process– Choice between imperfectly competitive market versus imperfect

regulatory process will depend on many region-specific factors– For more on this issue see Wolak, F.A. “Regulating Competition in

Wholesale Electricity Supply,” on web-site.17

Regulated versus Market Pricing

• Major problem with regulation– Firm usually knows its technological capabilities

and the demand that it faces better than the regulator

– This leads to disputes between the firm and regulator over minimum cost mode to serve demand that firm faces

– Regulator can never know minimum cost of providing service• Regulator can only know incurred costs of providing

service18

Regulated versus Market Pricing• Major problem with regulation (continued)

– There are laws against confiscating regulated firm’s assets• Impossible to tell difference between regulator setting

– Output prices that confiscate firm’s assets– Output prices that provide strong incentives for least-cost operation

– Long history of legal disputes in US that attempt to define process for setting prices that does not confiscate firm’s assets

– Firm understands value of superior information about its demand and technology in regulatory price-setting process

• Note: Effective regulatory process pushes this margin (making incurred cost = minimum cost) as hard possible, because consumers pay incurred costs

19

Regulated versus Market Pricing• Benefit of competition

– There are no laws against a firm’s competitors confiscating its assets through their output and pricing decisions• Any firm unable to cover its costs at the price set by market must exit

industry• High cost firms exit the industry and are replaced by lower cost firms

– Contrary to regulated regime, no need to determine if a firm’s incurred production costs are the result of a least-cost mode of production• If entry and exit barriers are low, then any firm that is able to remain in

business must be producing at or close to minimum cost

– Possibility of exit from industry and ease of entry provides strong incentives for minimum cost production under market pricing

20

Regulated Monopoly• Historical Benefits

– Economies to scale in generation of electricity• Average cost of generation declines as total output

increases

– Extensive transmission and distribution network necessary to deliver power • More than one network raises average costs

– Economies of scale and scope from having generation, transmission, and distribution in same geographic monopoly

21

Competitive Market (Benefits)

• Economies to scale and scope are less relevant than in early stages of industry– Technological change in generation and transmission– Economic growth has led to market demand that is large

relative to efficient size of new generation plant– Conclusion--modest or no economies of scale or scope

over relevant range of output

• Strong incentive to provide diversity of products consumers demand– Profitable niche markets

22

23

MC

Qd

PCompetition

A

TRCompetition = A + B TRRegulation = A

Quantity

Price

B

Pcomp > Preg = A/Qd

Pricing Under Competition Versus Regulation

24

MCRegulated

MCCompetition

QCompetition

PCompetition A

B

C

TRCompetition = A + C + D

TRRegulation = B + C + D

Quantity

Price

Prices Under Competition versus RegulationIf A < B, then competition allows consumers to pay lessIf MCreg > MCcomp then competition implies lower costs

D

TCCompetition = C

TCRegulation = B + C + D

Regulated versus Market-Pricing• When minimum cost of providing service is known,

little reason to run a market for service– Cost-of-service regulation can be used to set price

• When minimum cost of providing service is unknown, run a market to determine this cost– Markets provide strong incentives for minimum cost

production in both short-run and long-run– Not necessarily strong incentives to pass-on lower costs in

lower prices--market power problems

• Unless potential for significant cost reductions exist, introducing market pricing makes little sense

25

Regulation versus Competition• Considerable uncertainty over minimum-cost method to serve

electricity demand in both short-run and long-run• Two sources of supply-side benefits of restructuring

– In short-run, lower variable cost operating of existing fleet of generation units

– In long-run, lower cost investments in mix of generation capacity needed to meet future demand

• Tremendous uncertainty over least-cost way to serve future demand particularly in a carbon-constrained world

• Important Lesson from US—Avoid market rules that eliminate incentive for firms to reduce costs– Increases risk of that consumers pay market-clearing price

based on incurred costs rather than minimum costs• Few benefits to consumers realized from re-structuring

26

Using the Theory of Market Design to Improve Wholesale Market

Performance

27

Limiting Exercise of Market Power• To understand how to limit exercise of unilateral

market power need to understand how firms exercise unilateral market power– Limiting exercise unilateral market power will translate

production cost reductions into lower wholesale prices– Effective and transparent regulation of transmission and

distribution network services will translate wholesale price reductions into lower retail prices

• Mechanisms for limiting the exercise of unilateral market power in short-term wholesale market– Divestiture of generation units, Forward contracting,

Transmission network expansions, and Symmetric treatment of load and generation

28

Bidding in Competitive Markets• Qid: Total market demand in load period i of day d

• SOid(p): Amount of capacity bid by all other firms besides Firm A into the market in load period i of day d as a function of market price p

• DRid(p) = Qid - SOid(p): Residual demand faced by Firm A in load period i of day d, specifying the demand faced by Firm A as a function of the market price p

• id(p): Variable profits to Firm A at price p, in load period i of day d

• MC: Marginal cost of producing a MWH by Firm A• id(p) = DRid(p)(p – MC)

29

Residual Demand Curve faced by Firm

Price

DR(p)=Q

Quantity

Price

Quantity

SO(p)

QD

D- SO(p)

30

Calculation of residual demand curve: offers of all generators except Firm A

31

Calculation of residual demand curve for Firm A

32

Calculation of residual demand curve for Firm A

33

Bid to Maximize Profits Subject to Residual Demand

34

Profit-Maximizing Behavior• Profit-maximizing offer price above

marginal cost if residual demand curve is downward sloping

• Residual Demand Curve unknown at time generator submits bids– Demand uncertainty– Uncertainty about actions of other suppliers

• Optimal bid curve depends on distribution of elasticities of residual demand function

35

Bid to Maximize Expected Profits

Price

Quantity Q1 Q2

MR2 MR1 DR1

DR2

MC

P2

P1

S

36

Derivation of offer curve withflatter residual demands

37

Derivation of offer curve withperfectly elastic residual demand

38

Limiting the Exercise of Unilateral Market Power

• Make residual demand curve distribution perceived by all generation unit owners as flat as possible– Generator facing flat residual demand curve distribution is

unable to impact the market price with offer curves– Optimal strategy for generation unit owner is to bid marginal

cost curve (MC) as willingness to supply curve [S(p)]– If this is true for all suppliers, market prices will be as close

as possible to market designer’s optimum

39

Limiting Market Power

• Divestiture of Generation Capacity• Forward Financial commitments make firms bid

more aggressively in short-term market• Transmission upgrades to face all unit owners with

more elastic residual demand curves– Economic reliability of transmission network versus

Engineering reliability of transmission network

• Price Responsive Demand makes the residual demand curves perceived by all unit generation owners flatter

40

Divestiture of Generation CapacityChange SO(p) from SO1(p) to SO2(p)

Price Price

Quantity QuantityQd

DR1(p) = Qd – SO1(p)

DR2(p) = Qd – SO2(p)

DR1(pmax)

pmax

SO2(p)SO1(p)

41

Impact of Forward Contracts on Bidding Behavior

• QCid: Contract quantity for load period i of day d for Firm A

• PCid: Quantity-weighted average (over all hedge contract signed for that load period and day) contract price for load period i of day d

Price

QuantityQ

P

P

M

C

PM

2

1

C

Payments to Purchaser of HedgeContracts by Generators at

Payments to Generator by Purchaserof Hedge Contracts at

P

P

1M

2

M

42

Spot Market Bidding With Forward Contracts

• Assume market clearing price p is determined by solving for the smallest price such that the equation SAid(p) = DRid(p) holds.

• The magnitudes QCid and PCid are set far in advance of the actual day-ahead bidding process

• Generators sign hedge contracts with electricity suppliers or large consumers for a pattern of prices throughout the day, week, or month, for an entire or fiscal year

• Variable profits (profits excluding fixed costs) to Firm A for load period i during the day d at price p as: – id(p) = DRid(p)( p - MC) - (p - PCid)QCid

• This can be re-written as:– (p) = (DR(p) - QC )(p - MC) + (PC - MC)QC = DRC(p)(p – MC) + F

• Note that second part of expression is fixed from a day-ahead perspective.

43

Profit-Maximizing Output and Price With Fixed-Price Forward Contracts

44

For same residual demand curve, DR(p), a supplier with a fixed-price forward contract obligation finds it profit-maximizing to produce more output and set a lower market price

Profit-Maximizing Bidding With QC > 0 and QC = 0

(For Simplicity Assume MC = 0)

SNC(p)

SC(p)

DRHigh(p)DRLow(p)

DRHigh(p) - QC

DRLow(p) - Qc

QHContract

QLContractQL

NContract QHNContract

PLContract

PHContract

PLNContract

PHNContract

Expected Profit-Maximizing Bidding With QC > 0 and QC = 0

(For Simplicity Assume MC = 0)

45

Lessons for Transmission Network

• In vertically-integrated regime, single firm owns transmission network and all generation units needed to meet demand in firm’s service area– Network built to meet engineering reliability standards

• In wholesale market regime, transmission network operation and expansion decisions are separate from generation ownership and operation decisions– Network should be built to economic reliability standards

• Transmission network facilitates competitiveness of wholesale market– Transmission network configuration determines how many independent

suppliers are able to compete to supply energy at each location in wholesale market

46

Engineering Reliability• Enough transmission capacity so that

– Demand at all locations in network can be met with pre-specified probability

– Assuming that virtually all generation units in network are owned and operated by same entity

• Because of structure of regulatory process in former regime, strong incentive for vertically integrated (VI) firm to operate its generation units to limit congestion– VI utility interested in minimizing total cost of supplying

all of retail load– No incentive to operate high cost units more intensively to

increase locational price differences• This only increases total costs of VI utility which reduces its profits• Recall VI utility’s revenue stream is independent of its actions

47

Economic Reliability• Sufficient transmission capacity so that all locations in the

network face significant competition from enough independent suppliers to cause them to bid close to their marginal cost curve the vast majority of hours of the year– All suppliers face sufficiently flat residual demand curves a large

fraction of hours of the year– Expanding size of geographic market can only increase extent of

competition that suppliers face if there is adequate transmission capacity to allow that to occur

• Generation divestiture decisions can increase the economic reliability of a given transmission network– Conversely, to the extent that significant generation divestiture cannot

be implemented, more transmission investment may be needed to achieve economic reliability

• Transmission network facilitates commerce in same way that inter-state highway system facilitates commerce US economy– See Wolak (2011) “Measuring the Competitiveness Benefits of a Transmission

Investment Policy: The Case of the Alberta Electricity Market” on web-site

48

Lessons for Retail Market• Symmetric treatment of producers and consumers of

electricity– From perspective of grid reliability, a consumer is a supplier

of “negawatts”--SN(p) = D(0) - D(p)

• Default price for all consumers should be hourly wholesale price– Consumer is not required to pay this price for any of its

consumption, just as generator is not required to sell any output at spot price

– To receive fixed price, consumer must sign a hedging arrangement with load-serving entity or electricity supplier

• There is nothing unusual about hedging spot price risk– Health, automobile and home insurance, cellular telephone

49

Benefits of a Price Responsive Demand

Price

DR(p)=Q

Quantity

Price

Quantity

SO(p)

Q D

D- SO(p)

Q (p)D

DR(p)=Q (p)-SO(p)D

50

Price-responsive aggregate demand flattens residual demand distribution faced by all suppliers

Lessons for Distribution Network• Active participation of final demand in wholesale market

requires interval metering• Without interval metering can only sell electricity based on

monthly average price – Conventional meters only measure total monthly consumption of

electricity• Read meter at beginning of month and end of month, monthly

consumption is difference between two meter reads

• Firms have limited idea who in a given customer class is more expensive to serve in terms of wholesale energy costs

• With interval meters prices can differ across all hours of the month (hours of the day)*(Days of the Month),– p(h,d) = price for hour h of day d– Up to 744 prices per month

51

Universal Interval Metering• Cost is not a barrier to ubiquitous interval metering

In US, cost savings on manual meter reading comes very close to paying for cost of interval metering technology

• Price of metering technology falling rapidly• Sophistication of metering technology rising rapidly• Virtually all households have Internet access and can

receive price signals on real-time basis• Regulator can coordinate a competitive procurement

process for provision of interval metering infrastructure to regulated distribution companies Purchase cheapest meters that record hourly consumption

52

Challenges that Make Market Design Problem in New Zealand

Extremely Difficult

53

Vertical Integration• Four largest suppliers in New Zealand are vertically integrated

into retailing• Firms are called “gentailers”

• Vertical integration between electricity generation and retailing effectively eliminates beneficial incentive of fixed-price forward market obligations on supplier behavior

• A fixed-price forward contract between retailer and supplier within in same firm has no impact of supplier’s offer behavior• Supplier agrees to sell QC at PC to retailing affiliate• Retailer agrees to buy QC at PC from generation affiliate• No net impact of behavior of vertically-integrated firm because sale

and purchase nets to zero within firm• Gentailer still has same incentive to exercise unilateral market

power

54

Vertical Integration• Suppliers have little incentive to develop liquid market for

fixed-price forward contracts• They own physical assets needed to serve retail customers local to their

generation units• Developing a liquid forward market for energy would help retailers that

do not own generation units compete in their service territory• With vertical integration, fixed-price retail market obligations

with final consumers limits incentive of supplier to exercise unilateral market power, but only for duration of contract• Suppliers recognize that higher wholesale now prices can provide

rationale for raising retail prices in future• Vertical separation of generation from retailing creates level

playing field for retail competition• Provides strong incentive for retailers and generation unit owners to

enter into fixed-price forward contracts for energy

55

Hydro-Dominated System• Hydro-dominated system makes achieving competitive market

outcomes during low water conditions is extremely difficult• Hydro suppliers attempt to conserve water by submitting

steeper offer curves• Thermal suppliers perceive steeper residual demand curves

and submit steeper offer curves• Output prices rise because of steeper offer curves and

hydro suppliers find that they sell “too much water” and further steepen their offer curves

• Thermal suppliers respond by submitting steeper offer curves and prices rise further

• This dynamic has operated in all bid-based hydro-dominated markets around the world—New Zealand, California, Colombia, Spain

56

Hydro-Dominated System• If hydro suppliers have re-insured water shortfall risk with

thermal suppliers, impact of this dynamic can be limited• Suppose thermal suppliers sign contingent contract with

hydro suppliers to provide more energy at a fixed-price if water level falls below some pre-specified value

• Thermal suppliers have no incentive to raise wholesale price in response to steeper offer curve of hydro suppliers because they must make up hydro energy shortfall at fixed price• Contingent contract would involve up-front payment by

hydro suppliers to thermal suppliers for insurance against energy shortfall

• Vertical separation between generation and retailing can increase attractiveness of reinsurance for hydro suppliers and electricity retailers

57

Transmission Congestion• When transmission congestion in New Zealand occurs there

can be extremely large price differences across locations• Provides strong incentive for gentailers to consolidate load to

nodes near where it owns generation units• Increases riskiness of entry by retailer that owns no generation

• Buying out of short-term market to serve retail consumers can be extremely risky because of potential for congestion

• Finding a long-term hedge for locational wholesale energy price is difficult because firm most able to provide it is incumbent gentailer

• Market with long-term financial transmission rights and long-term energy contracts more likely to develop with less vertical integration

58

59

60

What is Next for New ZealandWholesale Electricity Market?

61

What is Next for New Zealand?• Major lessons from re-structuring processes around

the world– Decide which segments of industry will employ a

regulatory process to set prices and apply best possible regulatory mechanism• Transmission and distribution

– Decide which parts should use market mechanisms to set prices and apply best possible market mechanisms• Generation and retailing

– Implement proactive market monitoring process to detect and correct defects in market rules• Measures of ability and incentive of suppliers to exercise

unilateral market power• Measures of market performance relative to competitive

benchmark

62

What is Next for New Zealand?• Improving regulatory process

– Establish an explicit and publicly observable regulatory price-setting process for transmission and distribution services

– Regulated firms submit publicly disclosed annual reports on revenues and costs and assets and liabilities using international regulatory accounting standards

– Regulatory process for setting output price is public process were interested parties can participate and provide testimony to regulator

– Regulator can only rely on evidence presented in public process to arrive at regulated price• Failure to do so can result in decision being overturned on legal review

63

What is Next for New Zealand?• Regulatory process should

– Establish a rate base for regulated entities (RB)• Sum of past prudently incurred investment costs less accumulated

depreciation computed from publicly disclosed financial information

– Set risk-adjusted rate of return on capital (r) – Determine prudency of investment decisions (only

prudent investments are allowed cost recovery in output price)

– Set test year output level (Q)• Estimate variable cost of test year output (VC(Q))

– Set regulated price as p = (r*RB + VC(Q))/Q• Set single price for all customers of a given class

(residential, commercial, industrial) for transmission and distribution services for given distribution network area

64

What is Next for New Zealand?• On retailing and generation market competitiveness

– Single distribution and single transmission price for a given customer class for a given distribution network increases transparency of retail prices to final consumer

– Only reason for differences in retail price offers to customers by retailers is wholesale energy costs because transmission and distribution charges to serve customer are the same for all retailers

– Potential to increase competitiveness of retail market outcomes• Transparent transmission and distribution pricing will make it

easier to measure competitiveness of retail market outcomes• Implicit wholesale price = P(retail) – P(transmission) –

P(Distribution)• Data collection for retailing segment of industry to compute

average retail price which can then be used to assess competitiveness of retailing segment

65

What is Next for New Zealand?• Symmetric treatment of load and generation for customers

with interval meters– Retailer must pay actual cost of serving customer with interval meter

each half-hour of the day• Establishing interval metering as a regulated distribution

service in New Zealand seems cost effective– Encourage development of dynamic pricing of retail consumers to

increase competitiveness generation and retailing• Dynamic pricing—Retail prices that vary with real-time

system conditions– Time-of-Use pricing simply sets higher price in certain hours of day

regardless of real-time system conditions• Ample evidence in US, Japan, Europe of significant demand

reductions in response to dynamic pricing– Wolak (2010) An Experimental Comparison of Critical Peak and Hourly

Pricing: The PowerCentsDC Program– Ito (2013) Using Dynamic Electricity Pricing to Address Energy Crises:

Evidence from Randomized Field Experiments(with Takanori Ida and Makoto Tanaka)

66

What is Next for New Zealand?• Multi-settlement market makes active demand-side

participation much more straightforward that current single settlement market

• Large consumers and retailers can purchase energy in day-ahead market and sell it back in real-time– Avoids problem of selling something that consumer or

large retailer does not own• Real-time market price penalizes demanders that

consume more than day-ahead purchase– In single settlement market must come up with ad hoc

rules to penalize over-consumption relative to “purchased” amount

67

What is Next for New Zealand?• Address equity issues associated with higher

residential electricity prices– All US states and most industrialized countries provide

subsidized electricity to low income consumers– California has CARE program which provides subsidized

electricity to low income consumers – Low income consumers can pay a large share of monthly

budget on electricity• Particularly acute for low income consumers on South Island

– An important role of regulatory process in the US is to protect those consumers that find it hard to protect themselves

• Higher income consumers should be able to take actions to reduce bill– Switch suppliers, install technology to increase flexibility of their

half-hourly demand

68

What is Next for New Zealand?• Transmission expansions to reduce frequency and

magnitude of congestion– Limits geographic basis risk to new entrants to retail

markets distant from their generation units or forward contract delivery points

– Transmission expansions increase number of half-hours per year each generation owner faces competition from all generation unit owners in New Zealand• Makes distribution of residual demand curve a generation unit

owner faces flatter, reducing its ability to exercise unilateral market power, which Increases the competitiveness of short-term market outcomes

• Transmission planning process that accounts for these consumer benefits will improve competitiveness of wholesale market outcomes

69

Vertical (Dis)-Integration?• Separating generation from retailing would certainly

help, but there are other less extreme regulatory interventions

• Proactive market monitoring process for wholesale and retailing segments of industry that measures performance of these two markets can assist in design of appropriate interventions– Andrew Philpott (University of Auckland) excellent work on

computing competitive counterfactual wholesale market price – Develop methodology to derive counterfactual competitive retail

price– Regulator adopts “official price benchmarks” and collects data

necessary to compute them• Improves regulatory credibility (experience from California)

– Comparing benchmarks to actual market outcomes can diagnose possible market design flaws and design interventions that improve market performance

70

Process of Continuous Improvement• All wholesale electricity markets must adapt to

changing technology, policy goals, and market participant behavior

• Proactive market monitoring process is key to adapting to changing circumstances

• All regulators must engage in critical self-assessment of market performance relative to competitive benchmark to ensure consumers benefit from electricity re-structuring

• Recall that process of finding optimal market design in other industries is not available for electricity– Market monitoring process can point the way to “optimal

market design,” but this is process of continual learning and implementation of knowledge

71

Conclusions• New Zealand faces many difficult challenges in achieving a restructured

market that benefits consumers• Best practice regulatory process for monopoly segments and market

monitoring and market rule making process can achieve this goal– Recognize and embrace fact that managing unilateral market power is major

challenge of wholesale market regime• Regulate monopoly segments to enhance competitiveness of wholesale and

retail segments– Push on margin of making incurred cost equal minimum cost– Transparent distribution and transmission pricing– Active participation of final consumers in wholesale market– Transmission planning process that accounts for competitiveness benefits of

expansions• Design market rules to limit adverse impact of vertical integration and

hydro-dominate electricity supply– Data collection and market performance measurement and monitoring crucial to

this process

Related papers and presentations athttp://www.stanford.edu/~wolak

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73

Bid-Based versus Cost-Based Markets in Hydro-Dominated Electricity

Supply Industries

74

Cost-Based Markets in LACs• Several hydro-dominated Latin American Countries (LACs)

have a long history with electricity supply industry re-structuring using a cost-based short-term market– Chile has had a wholesale market since mid-1980s

• Almost 300% increase in capacity since 1990, all privately financed– Argentina has had a wholesale market since early 1990s– Brazil, Peru, Panama, and Guatemala also run cost-based markets

• Under a cost-based market, suppliers submit technical characteristics of their generation units to market operator– Heat rates, variable operating and maintenance costs

• Market operator computes variable cost of generation units using input fuel prices and from this information computes opportunity cost of water, usually by solving a stochastic dynamic program

• Market operator dispatches units and sets market-clearing prices using these variable cost estimates– Galetovic, Munoz, and Wolak (2013) summarizes dispatch and pricing

process for Chilean market– Wolak (2008) discusses the case of Brazil

75

Cost-Based Markets in LACs• Experience of Chile is generally thought to be a success

– LACs focus on what is needed to attract new investment—active forward market

– Based on US experience, it is difficult to argue that bid-based short-term markets have benefited consumers

• Many opportunities for suppliers to exercise unilateral market power• LAC cost-based market focuses on development of forward

market for energy– Short-term market used to clear imbalances relative to forward

market positions– No regulatory intervention in market for fixed-price forward

contracts between generation unit owners and retailers– However, because of cost-based short-term market, retailers have

limited incentive to sign fixed-price forward contracts

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Downside of Cost-Based Markets• Mandated forward contracting levels for retailers enforced

by regulator– Specify minimum hedging requirements at various time horizons

to delivery, for example• 95% coverage 1-year in advance of delivery• 90% coverage 2-years in advance of delivery• 85% coverage 3-years in advance of delivery

• Contracting levels enforced by penalties set by retailers• Specify cost-of-shortage in stochastic dynamic program

used to compute opportunity cost of water– Political pressure to set low cost of shortage, which sets low wholesale

prices in a cost-based market– Low cost of shortage makes shortage periods increasingly likely because

it sets a low opportunity cost of water and more water being used• Brazil, Chile and other cost-based markets have faced

several shortage periods when firm load had to be curtailed

Old Problems in New Regime• Technology of production dictates single

transmission network and distribution network for a single geographic area– Regardless of market structure—vertical integration or wholesale

market• Regulation of prices transmission and distribution

owners charge, operating behavior, and expansion network decisions needed under either regime– In former regime it was done implicitly through the retail price– In new regime it must be done explicitly

• Standard regulatory challenges remain in new regime– Asymmetric information between firm and regulator about minimum

cost mode of supply– Determine prudency of investment and operating decisions– Provide incentives for least cost production

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New Problems in New Regime• New regime requires regulatory process to design

wholesale market and monitor its performance• Firms in all industry segments will attempt

maximize profits subject to mechanism used for regulated segments of industry– Regulator must recognize and account for fact that all

market participants behave strategically• Market design and market monitoring process can

have an enormous impact on market outcomes• Rather than set prices that are “just and reasonable”,

regulator must now implement market rules that result in market prices that are “just and reasonable”– Massively more complex task (economists can help)

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Adam Smith on Market Design

• “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages.”

The Wealth of Nations, Book I Chapter II

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