How to Make Competitive Network Industries Benefit Consumers

1. How to Make Competitive Network Industries Benefit Consumers Frank A. Wolak Department of Economics Stanford University Stanford, CA 94305-6072 wolak@zia.stanford.edu http://www.stanford.edu/~wolak Chairman, Market Surveillance Committee California ISO

2. Outline of Talk • Regulation versus competition • Costs versus benefits • Essential role of retail market • Difficulty with hybrid markets • Greater need for explicit protection of low-income consumers • Financial and informational assistance • Changing role of regulator under competition

3. Regulated Monopoly • Benefits of vertically-integrated monopoly • Economies to scale in production • Technology is such that 1 percent increase in inputs causes greater than 1 percent increase in outputs • Extensive network necessary to deliver product • More than one network raises average costs • Lost economies of scale and scope • Single firm under government control makes it easier to pursue policymaker’s goals • Can maintain cross-subsidies across services

4. Regulated Monopoly • Costs • Although the potential exists for the monopoly to realize economies to scale and scope • Reward structure due to regulatory process gives little incentive for least-cost production • Political environment firm operates in makes least-cost operation just one of many goals • Conclusion--Least-cost production does not occur and limited economies to scale and scope are realized

5. Regulated Monopoly • Major problem with regulation • Firm usually knows its technological capabilities and the demand that it faces better than the regulator • This leads to dispute between firm and regulator over minimum cost mode to serve demand firm faces • Regulator can never know minimum cost of providing service • 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 do not confiscate firm’s assets • Firm understands value of superior information about its demand and technology in regulatory price-setting process

6. Regulated Monopoly • Costs (continued) • Monopolist has little incentive to provide diversity of products consumers desire • Purchase good offered by monopolist or nothing • Monopolist has little incentive innovate to reduce costs or discover superior good • Innovation takes effort, but cost reduction is immediately reflected in lower rates • Monopolist may be happy with “quiet life”

7. Regulation versus Competition • Benefit of competition • There are no laws against a firm’s competitors confiscating the firm’s assets through their output and pricing decisions • Any firm that is unable to cover its costs at the price set by market will exit industry • Nature of competition among firms leads high cost firms to exit the industry and be replaced by lower cost firms • Contrary to regulated regime, no need to determine if a firm’s incurred production costs are the least-cost mode of production • If market is competitive, then any firm that is able to remain in business must be producing at or close to minimum cost • Possibility of exit from industry provides strong incentives for minimum cost production under competition

8. Competitive Market • Benefits • Privately-owned, profit-maximizing firm has a strong incentive to produce at minimum costs • Any cost reductions not duplicated by competitors translate one-for-one into higher profits • Privately-owned, profit-maximizing firm has a strong incentive to innovate • Any cost reduction not duplicated by competitors yields higher profits • New investment decisions based on market price • Purely economic basis for new investment

9. Competitive Market (Benefits) • Economies to scale and scope are less relevant than in early stages of industry • Technological change allows smaller minimum efficient scale of production • Large market demand relative to smaller minimum efficient scale of production • 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

10. Competitive Market • Costs • Firms in a competitive market have little incentive to pass on cost reductions to consumers in the form of lower prices • Firms exercise all available unilateral market power • Same as serving fiduciary responsibility to shareholders • Actions can set prices far in excess of competitive levels • Existing firms may takes actions to prevent entry by new firms • Competitive markets make it virtually impossible to maintain cross-subsidies in prices across services and/or consumers.

11. Regulation versus Competition • 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 • Competitive markets provide strong incentives for minimum cost production • Not necessarily strong incentives to pass-on lower costs in lower prices--market power problems • Unless potential for significant cost reductions exist, introducing competition makes little sense

13. Price MCRegulated TRCompetition = A + C TRRegulation = B + C B MCCompetition PCompetition A C QCompetition Quantity Pricing Under Competition versus Regulation

14. Regulation versus Competitionin Electricity Supply • Technology for delivering electricity implies • One transmission and distribution grid needed for a given geographic area • Competition among multiple networks would lead to single dominant network • 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 government oversight • Unregulated monopoly can set prices for use of network that extracts all monopoly profits from electricity supply

15. Regulation versus Competitionin Electricity Supply • In competitive generation regime, unregulated monopoly supplier of transmission and distribution services can set prices for use of network that results in monopoly price for delivered electricity • Price of transmission and distribution services must be set by independent regulator or government • In vertically-integrated monopoly regime, unregulated firm can set monopoly price for delivered electricity • Output price of vertically-integrated monopoly must be set by independent regulator or government • Both regimes require regulation of some services

16. Regulation versus Competitionin Electricity Supply • Competitive regime restricts regulated portion of industry to smallest entity possible • Transmission and distribution are only regulated services in competitive regime • Generation and electricity retailing are open to competition • 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 on which regime yields lower prices to consumers

17. Regulatory Reasonableness Problem of Retail Rates Maintaining single monopoly retailer of electricity in competitive generation regime implies that regulator must continue to determine prudence of all energy and ancillary services purchases Regulator must run an energy trading firm to determine prudent forward versus spot market purchases by monopoly retailer Regulator must avoid significant temptation to second-guess itself after the fact if spot price is significantly below forward contract price Extremely difficult, if not impossible, for regulator (or any other entity) to determine if forward contracting behavior was prudent ex post Consumers comfortable with buying price insurance that is ex post unprofitable. Regulators are not so comfortable.

18. Why Retail Competition is Essential When minimum cost of providing service or product is unknown, run a market to determine this cost Competitive markets provide strong incentives for minimum cost production Minimum cost of procuring wholesale energy and ancillary services is unknown and extremely uncertain A market is needed to find this minimum cost and determine which firms are good at this and which are not Retail competition provide natural mechanism to pass on wholesale price increases and decreases

19. Role of Retail Competition • Pass-through of wholesale price signals • Retail competition is most politically viable way to accomplish this • Regulator has very hard time raising retail price even with huge observed run-up in wholesale price • Privately owned profit-maximizing firm as very little problem raising retail prices if wholesale prices rise • Hedged consumers win, consumers on spot market lose • If spot price falls, opposite result occurs • Retail competition can provide full diversity of product offerings (pricing and reliability options) consumers demand • Competition provides strong incentives to serve all profitable niche markets • Consumer has choice among products offered by all competitors • Can purchase lighting, heating, cooling needs from separate providers • To do this requires real-time metering for each service • Can only bill consumer for unit of time or at service that you can measure consumption

20. Retail Competition Requires Facing Consumers with Real-Price Risk • Currently amount fixed-price customers pay to retailer for energy annually is expected to cover total annual energy costs • This is true whether or not consumer is exposed to real-time price risk • Mandatory exposure to real-time price risk gives customer the option to make forward contract commitment to receive fixed retail price or manage price risk for lower average price • Analogous to purchasing airline 3 weeks in advance with Saturday night stay-over • If purchase ticket at last minute someone must face spot price risk • Unless require forward hedging--this will be retailer, • This creates potential for unhedged wholesale spot price above fixed retail default provider rate • Only mandatory exposure to real-time price risk with ability of consumers to hedge this price risk solves this problem

21. Involving Final Demand • All customers must eventually face real-time price risk • Otherwise full benefits of competition will not be realized • Customer has option of fixed retail price by hedging real-time price risk through long-term commitment (annual cell phone price plans) • Real-time pricing should be default for all large customers • Customers with sophistication to manage price risk • Requires real-time metering technology • Residential and small business customers should transition to real-time pricing scheme • At start of market set fixed-price default provider rate using vesting contract wholesale price plus stranded asset recovery rate • Default provider rate should be set to give customers incentive to take on real-time price risk • All retailers must offer fixed-price default provider rate, but they can also offer any other pricing plan

22. The Role of High Prices • Involving demand in the market requires long-lived, irreversible investments • Without constant threat of high prices demanders will not make necessary investments • Don’t save any money from investment • May be cheaper to work to continue price caps • Carrot and stick approach by regulators • Carrot--subsidies to early adopters of demand response technologies • Stick--promise of removal or lifting of safety nets in future

23. Real-Time Pricing not Time-of-Use Pricing Consumers must pay hourly wholesale price in hourly retail rate Time-of-use pricing provides limited signals to consumers to respond to real-time wholesale prices Time-of-use pricing creates the same basic incentives as fixed-rate billing scheme Time-of-use pricing may not yield lower average spot electricity prices or increase incentives for generators to sign low-priced forward contracts Time-of-use pricing creates similar incentives to those from load-profile billing

24. Load-Profile Billing • Measure total monthly consumption of electricity • Representative load shape used to compute weighted-average energy price for month • p(h,d) = price for hour h of day d, • w(h,d) = weigh for hour h of day d, • Monthly bill = (monthly consumption) x (monthly weighted-average energy price). • Demand reduction when hourly energy price is $0/MWh leads to same monthly savings as same demand reduction when hourly price is $250/MWh. • Want consumer to realize maximum benefit from reducing consumption when wholesale price is highest • Imagine difficulty in running competitive long-distance telephone company only measuring minutes of phone use per month

25. Robust Retail Competition Requires Real-Time Metering • Without real-time metering, competition takes place on one dimension • Monthly average price • Recall that conventional meters only measure total monthly consumption of electricity • Firms have no idea who in a given customer class is more expensive to serve in terms of wholesale energy costs • No surprise there is little retail competition • With real-time meters competition can take place on • (hours of the 24)*(Days of the Month), p(h,d) = price for hour h of day d • May not need all of these dimensions, but with widespread real-time metering there will be robust retail competition • Recall dimensions that service measurement in telephony

26. Real-time pricing contracts • All England and Wales retail customers have option to purchase hourly consumption according to hourly pool price plus transmission charge • Many large industrial customers purchase according to this pool price contract • “Estimating the Customer-Level Demand for Electricity Under Real-Time Market Prices” Patrick and Wolak • Estimate half-hourly price responsiveness of a sample of large industrial and commercial customers in England and Wales • Significant price response from all classes of industrial customers--water suppliers, industrial process plants, retail stores

27. Limited Benefits of Restructuring Without Involving Demand • US has privately-owned, profit-maximizing firms facing cost-of-service price regulation or incentive regulation plan • Detailed prudence review of investment • Hard to argue there are large deviations from minimum cost production • Vertically integrated ownership and centralized dispatch should be able to improve on bid-based dispatch on true production cost basis

28. Markets use prices to allocate scarce resources • Competitive market should be able to get by with lower level of capacity and serve same customers • This implies lower capacity costs for market at large • If dispatch costs are close to the same, then average price in competitive market should be less than average price in regulated market • A necessary condition for this to occur is a sufficient number of price-responsive consumers

29. Optimal Capacity Choice Under Regulation versus Competition Kreg >> Kcomp

30. Example--US Airline Industry • Load Factors = (Seats Filled)/(Seats Total), • In regulated regime highest load factors approximately 55% in 1976 • Currently Load Factors are close to 73% • This increased capacity utilization rate allows real average fare per passenger-mile to be significantly less than under regulated regime • Regime works because of large number of sophisticated price-responsive consumers.

31. Implications for Re-structuring • For consumers to benefit from a competitive market they must face to real-time hourly price signals • In competitive market a firm must make profits on each customer • Regulated firm only needs to make profits across all customers • All customers with same cost to serve will face same price in competitive market

32. Implications for Re-structuring • Inability to cross-subsidize under competition • Requires greater attention to protecting low-income consumers from high prices that may impoverish them • Regulator may need to require explicit subsidies • Regulator must provide significantly more information to consumers to help them protect themselves • Emphasize importance of hedging spot price risk • Information on load-shifting technologies

33. New Role of Regulator • Solve Market Design Problem • Set number and size of market participants • Set rules for determining revenues each firm receives • So that combined actions of each participant acting in its own best interest • Yields market outcomes as close as possible to regulator’s desired outcome • Political constraints often imposed on process • Difficult to break-up incumbent monopolist

34. Restructuring Process • Requires far more sophisticated regulator • Regulating a vertically-integrated monopoly • Determine prudently incurred costs of production • Set output prices to allow recovery of these costs • Set just and reasonable prices • Regulating a competitive market • Determine market rules that result in competitive market outcomes • Determine just and reasonable market rules • Regulatory rules can give enormous competitive advantages to some market participants • Regulator must explicitly account for this regulatory decision-making process

35. Restructuring Process • Regulator must be very suspicious of the impact of rule changes on market outcomes • When firm asks for market rule change regulator should perform following thought experiment • How could this proposed rule change be used by firms in the market to increase their profits and therefore raise prices paid by consumers? • In competitive market it very hard for a regulator to make a firm to do something that is not in firm’s financial interest

36. Competition Can Benefit Consumers • No free lunch • Benefits from re-structuring must come from a change in behavior of market participants • Firm operate more efficiently • Short-term operation at least cost • Investment decisions based on market signals • Consumers make greater effort to use existing capacity more efficiently • Get by with less capacity to serve same number of consumers • Holding excess capacity is costly, because capital costs of unused capacity must be paid for regardless

37. What is Market Power? • Ability of a firm to increase the market price and profit from this price increase • In all markets, firms continually attempt to exercise market power • Desire to serve interests of shareholders => maximize profits => exercise all available unilateral market power • Competitiveness of market judged by how fast potential or actual competitors and/or consumers respond to foil these attempts

38. Measuring Market Power • Market power cannot be assessed based on market structure alone • Concentration measures can be misleading • Whether market power is possessed by a market participant is not a yes/no decision • All players possess some market power • At issue is how much market power is too much • In bid-based electricity market can compute explicit measures of market power • Price elasticity of residual demand

39. Residual Demand Curve

40. Profit-maximizing behavior implies an optimal bid price above marginal cost • 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 • Hourly variable profits of firm as a function of market-clearing price, P: B(P) = DR(P)(P - MC)

41. Best-Response Price (PB) Given Residual Demand Curve

42. Best-Response Supply Curve (S(p)) for Uncertain DR(p,)

43. Market Power in Spot Market • If one firm is large enough to affect price, it has an incentive to restrict output or raise its offer price on marginal units of output in order to raise the market price on all units • A producer may not have to be very large to do this in electricity markets because: • Period-level demand elasticity close to zero • Very high cost of storage • Strict capacity constraints on production

44. Qd . Price 1 2 3 4 5 6 7 8 9 10 Quantity Market Power with Inelastic Aggregate Demand Ten Equal Size Firms

45. All Firms Are Pivotal Price DR() Quantity

46. Pivotal Bidder • Residual demand faced by Firm A is positive for all prices • In this case, Firm A is called a pivotal bidder • Mathematically, DR() > 0 • Given bids of other firms, at least DR() from Firm A is required to satisfy market demand • Extreme case of market power • No matter how high a price Firm A bids for DR(), it will set market-clearing price • In all electricity markets, there are system conditions when some firms are pivotal

47. Market Design Goal • Make spot market residual demand curve perceived by all unit owners as elastic as possible • Generators facing infinitely elastic residual demand curve perceive themselves as being unable to impact the market price by their bids • Optimal strategy for generation unit owner facing infinitely elastic residual demand curve is to bid marginal cost curve as willingness to supply curve • This will lead to market prices as close as possible to market designer’s optimum

48. Financial hedge contracts Forward financial contracts exert a major impact of bidding behavior in electricity spot markets Forward financial contracts are 1) Bet between seller (usually generator) and buyer (usually load-serving entity) on spot price 2) Number of units of bet taken is contract quantity Two-sided forward contract or contract for differences (CFD) pays out (P - PC)QC to buyer of contract (amount can be positive or negative) Impact of hedge contracts on spot market bidding behavior in Australian Electricity Market studied in Wolak (2000) “An Empirical Analysis of the Impact of Hedge Contacts on Bidding Behavior in a Competitive Electricity Market,” International Economic Journal, Summer, 1-40.

49. Two-Sided Hedge Contract Payments Streams

50. Bid-Based Market with Hedge Contracts In NEM1, each day d is divided into the half-hour load periods i. 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 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 for Firm A. MC: Marginal cost of producing a MWH by Firm A id(p): Variable profits to Firm A at price p, in load period i of day d