The Economics of the Exelon/PSEG Merger

1. The Economics of the Exelon/PSEG Merger Eric Emch, OECD eric.emch@oecd.org

2. Outline of Talk • Overview of US regulatory environment II. Competition policy in electricity markets III. Background on the merger IV. Economic analysis VI. Outcome/final thoughts

3. Brief History of Deregulation • 1992: Energy Act • Authorized Federal Energy Regulatory Commission (FERC) to require utilities, on a case-by-case basis, to provide other wholesale buyers and sellers access to their transmission line • Created new class of generators to compete with traditional utilities • 1996: FERC Orders 888 + 889 “open access rule” • Opened transmission systems of investor-owned utilities to all qualified wholesale buyers and sellers • Required corporate separation of generation from transmission • 1999: FERC Order 2000 Encouraged all privately owned utilities to place their transmission under regional transmission organization (RTO) • Non-discriminatory transmission access administered by RTO • Each designs its own market mechanism, within certain parameters

5. Immediate Problem:CA Electricity Crisis of 2000-2001 • Market began operating in April 1998 • Wholesale prices determined by day-ahead auction, retail prices still regulated • CAISO (California Independent System Operator) supervises market system and acts as supplier of last resort • Prices skyrocket in April 2000 and stay high for the following year • Disruptions in supply, rolling blackouts • Two of three state retail utilities declare bankruptcy, California Power Exchange declares bankruptcy • In the end, FERC re-establishes price controls in 2001

6. CA Price Spike in 2000-2001 October 2003.: Schwarzenegger wins special recall election Source: June 2002 GAO Report “Restructured Electricity Markets”

7. What Went Wrong in California? • Some explanations that have been given: • Supply and demand shocks: difficult for new transmission to come online, unusually warm weather, also dry weather that meant less hydro • Exploitation of market power inherent in the market structure, exacerbated by: • Lack of long-term contracts, due to market rules that hindered usage of long-term contracts and encouraged purchases on the spot market • Vertical dis-integration: state encouraged utilities to sell off generation; may have exacerbated market power problems • Retail prices still frozen – no demand response • Prevailing view among economists is that flawed market rules and oversight led to exploitation of market power by participants in the market

8. California Postscript • FERC ultimately re-imposed price caps in California. State began to re-design electricity market. • Vertical integration / long-term contracting helped limit exercise of market power in other markets, while lack of such integration / long-term contracting led to problems in CA • E.g., Bushnell, Mansur, and Saravia (2007) “Vertical Arrangements, Market Structure, and Competition…” NBER Working paper #13507.

9. Prices in other markets Source: Bushnell, Mansur, and Saravia: “Vertical Arrangements, Market Structure, And Competition: An Analysis of Restructured U.S. Electricity Markets.

10. Local electricity markets in US • Diversity of approaches by geographic region; some essentially fully regulated. Wholesale much more deregulated than retail, generally. • Many parts of the government still involved in the markets in some way • FERC: Overall oversight, able to withdraw permission to operate RTO market, or to cap prices • RTO: Direct oversight of particular market; sets market rules • State public utility boards/state legislatures: especially in remaining retail price regulation, siting and transmission issues • Nuclear Regulatory Commission (NRC) for nuclear plants • Also, standard antitrust oversight by US DOJ and FTC

11. Role of Competition Policy • Merger policy: • Prevent accumulations of market power via merger, in a type of market that can be particularly prone to exercise of market power • Section 2/Article 82 Abuse of dominance • Much concern of FERC about discriminatory access to transmission rights when setting up deregulated market; some potential vertical issues regarding pipeline supply, etc. in some markets • Section 1/Article 81 Price fixing • Coordinated efforts to control prices could in theory be an issue, but no recent DOJ/FTC cases in electricity markets

12. Electricity Mergers: Difficult Issues • Very inelastic demand • Consumers often don’t face true prices • Many retail prices still regulated • Even when not regulated, are not usually set based on real-time wholesale prices (except perhaps for large industrial customers) • Limited efforts to introduce real-time pricing • Non-storability of electricity: consumers can’t spread demand over time • Shape of supply curve means that withholding small amount of electricity from market at the right time can lead to large price swings, if price is set at highest bid. Large share not required for large impact on the market.

13. Source: US Dept. of Energy/Energy Information Administration

14. Sample Supply Curve Source: Speech of AG Tom Barnett before NY State Bar Association, Jan. 25, 2007. Note: For illustrative purposes only – not an actual representation of market conditions.

15. Electricity Mergers: Complexity • Traditional presumptions based on market share can be misleading • The effect of combinations of assets on the incentive and ability of a firm to exercise market power vary dramatically depending on location on the supply curve. Simple capacity-based market shares don’t necessarily capture this. • For instance, combination of baseload (e.g., nuclear) plants may give a large market share but leave the firm with very little ability to withhold output because it can be very difficult and costly to withhold baseload output. On the other hand, a large share of baseload power could provide incentive for withholding a small number of higher-cost “ability” assets acquired via merger. • Presence in the downstream retail market can affect incentives to exercise wholesale market power. • Geographic and product markets vary hourly based on supply and demand conditions. Potentially a very large number of discrete markets to analyze.

16. Merger Background • In late 2004, Exelon Corp. announced a $16 billion merger with Public Service Enterprise Group (PSEG) • Exelon owns 25,000 MW of generating capacity, PSEG 15,000 MW. • Overlaps in wholesale electricity generation in PJM region, as well as ancillary services such as spinning reserves, regulation, and generation. • Each also had downstream retail commitments, Exelon via PECO, PSEG via participation in New Jersey BGS auction for retail load. • Exelon has significant low-cost nuclear and hydro, relatively fewer high-cost “ability” assets. PSEG the reverse. Combination of incentive and ability particularly dangerous. • Raw market shares/capacity in PJM pre merger: • “PJM East”: Exelon 20%, PSEG 29% of capacity. > $10 billion in electricity sales . Interface constrained 1,397 hours in 2005. • “PJM Central/East”: Exelon 19%, PSEG 21% of capacity . Roughly $19 billion in electricity sales. Interface constrained 1,916 hours in 2005.

17. The PJM RTO

18. The PJM RTO • Has been growing. Originally covered mostly Pennsylvania, New Jersey, Maryland (hence name), has expanded in recent years. • Day-ahead and real-time auctions for electricity, along with long-term contracts for power and many purely financial transactions for hedging and other purposes • Units are called in “merit order,” from lowest to highest offer. Auction pays all generators the highest price bid that is accepted. • PJM Board is made up of 10 people, nominated by members, who represent utilities, generation owners, and transmission owners. Once on the board, independent of members. Can step in to cap prices in areas if certain structural conditions are met. • FERC has overall supervision of RTO, but does not intervene on a day-to-day basis. Can declare the market no longer workably competitive, or can intervene if rates are not “just and reasonable.”

19. The Merger • Exelon claimed that the merger would yield efficiencies (increased output) in operation of nuclear power plants • Some evidence of scale/scope effects in nuclear generation. Exelon nuclear facilities operated more efficiently than PSEG. Question as to whether or not this is merger-specific: might be achieved by contract? • Potential for higher prices as well • Simulations submitted by 3rd parties in FERC proceedings showed large price rises due to unilateral incentive to withhold electricity post-merger. • Regulatory thicket • FERC, PaPUC, NRC, DOJ, NJPUC all had to approve

20. FERC Review • Focused on market share screens in different demand periods (ex., winter peak, summer off-peak) • Parties offered divestiture package of 2900 MW that would reduce the change in concentration of the merger within acceptable limits during these periods, within in particular subsets of PJM • Proposal included 2600 MW of “virtual divestiture” of nuclear output • Commitment to pre-sell nuclear output via 15 year contract or rolling 3-year contracts

21. Parties’ FERC Analysis

22. Problems With FERC Review • Geographic markets not rigorously defined • Bands for determining market shares are somewhat arbitrary • Market share is a first step, but should not be the end of the analysis • Doesn’t take into account lifespan or other characteristics of particular units. Specific divestitures undefined • “Virtual divestiture” may not mitigate incentives as much as actual divestiture • DOJ Conclusion: merger with FERC-approved mitigation would still lead to higher prices

23. Economic Analysis: Market Definition • Product market: Energy at a particular day and time of the day. So, in reality, tens of thousands of different product markets. Deal with this by simulating effects at many different times. If enough data, all times. • Geographic market: From where can electricity be drawn to serve customers in the region? • In times of low demand, energy can be pulled from virtually the entire region, as well as outside the region • In high demand, load pockets form, and prices separate in distinct geographic areas via PJM Locational Marginal Pricing (LMP) system • Mapping prices at particular times of day can show relevant geographic markets

24. Large Geographic Market in Unconstrained Hours Source: Public Service Commission of Maryland, Electric Supply Adequacy Report of 2007

25. Narrow Market in High-Demand Hours with Transmission Constraints Source: Public Service Commission of Maryland, Electric Supply Adequacy Report of 2007

26. Economic Approaches For Determining Effects • Market shares • First step, but limited and flawed • “Length analysis” • Less crude than market shares, doesn’t require much additional data • Simulation methods • Bid simulation • Residual demand • Supply function equilibrium

27. Role of Vertical Integration/Forward Contracting • Market shares do not take into account downstream commitments by wholesale sellers • Incentive to raise price in the wholesale market depends on the extent to which firm is a net seller (“long”) or net seller (“short”) in wholesale market • Retail commitments or long-term contracts to supply energy can mitigate incentives to raise prices by making a firm shorter in the market • For background, see, e.g., Lien, J. (2000) ‘Forward Contracts and the Curse of Market Power,’ University of Maryland Working Paper.

28. “Length Analysis” of Merger • The “length” of a particular firm is the extent to which it is a net buyer or seller. A firm with lots of generation and no downstream commitments is “long,” a net seller. • Incentive to withhold a particular plant at a particular time depends on market price and the owner’s length at that time relative to that plant • A sufficient condition for no harm from a merger is that the length behind each asset is reduced post-merger. Can achieve this with targeted divestitures. • Even if this sufficient condition isn’t met, can perhaps balance reduced length behind some assets versus increased length behind others to arrive at no net harm

29. Simulating Effects of Merger: Bid Simulation • If historical bid data are available, and information about parties’ downstream and forward commitments, can calculate merging parties’ optimal withholding strategy had they been merged in period of examination, holding existing bids constant. • Tricky issues: • Geographic markets are endogenous (but can approximate based on historical patterns) • Comparing simulated future to actual past may not be the right baseline, if simulation is only an approximation of actual behaviour. May need to create simulated baseline if pre-merger simulation doesn’t match up with reality. • Doesn’t account for strategic responses by other players in the market after the merger. Need to argue that they are too small to be strategic or that ignoring this is conservative. Alternatively, can try to simulate equilibrium of large players. • See, e.g., Wolak, F. (2000) ‘An Empirical Analysis of the Impact of Hedge Contracts on Bidding Behavior in a Competitive Electricity Market’, International Economic Journal, 14(2), 1–40.

30. Simulating Effects of Merger: Residual Demand Analysis • Gathering and processing bid data, even when available, can be complicated and costly. • As an alternative, can assume all firms but merging firms offer assets at cost before and after merger. Simulate merged firms optimal withholding pre- and post-merger. • May not be far off if market is relatively unconcentrated. Or, might argue this is conservative, if one firm’s withholding leads other firms to withhold further. • Examine different demand states and weight based on historical frequency. Compare withholding by independent firms pre-merger to combined firm post-merger. • Complication: Need pre-merger equilibrium concept. Can try Cournot equilibrium or simply compare to larger of two pre-merger firms to the post-merger firm. • See, e.g., Gilbert and Newberry, “Analytical Screens For Electricity Mergers,” (forthcoming, Review of Industrial Organization, 2007)

31. Simulating Effects of Merger: Supply Function Equilibrium • One difficulty with the previous approaches is that they assume perfect foresight on the part of firms. Actually, firms can’t optimize withholding each hour of the day. They bid supply functions, not amount of withholding. • Given some limitations on types of functions that can be bid into the market, can in theory calculate of firms’ optimal equilibrium supply function bids. • Need to compare outcome of this procedure to actual outcomes to calibrate model. • Problem: in practice, supply function equilibrium may have no solution or multiple solutions. Hard to solve except numerically, and no guarantee iterative procedure will end up with only solution. • See, e.g., Klemperer P. and Meyer M. “Supply Function Equilibrium in Oligopoly under Uncertainty,” Econometrica, 57(6): 1243-77.

32. DOJ Remedy • DOJ remedy went beyond FERC remedy, and called for targeted divestiture of six key plants which included key baseload coal and mid-merit natural gas capacity, along with numerous peaking assets • Importantly, divestiture allowed parties to retain both sets of nuclear plants, a source of potential efficiencies • Even recent critics of Antitrust Division such as American Antitrust Institute hailed the divestiture package as sufficient to mitigate post-market power. Little opposition by either AAI or interested parties in wake of DOJ filing. • Merger ultimately withdrawn, however, due to opposition from the New Jersey Board of Public Utilities, the only regulator not to approve merger

33. Final Thoughts • Market power in electricity markets can be particularly easy to exercise, and dangerous for consumers • Market shares, a traditional foundation of merger analysis, not as useful in analyzing electricity mergers • Wealth of data relative to some other markets, however, may allow more rigorous simulation methods for calculating merger effects • Analysis should consider effects of downstream retail commitments and forward contracts on incentives to withhold

34. Some References • Armington, E., Emch, E. Heyer, K. (2006), “Year in Review: Economics at the Antitrust Division 2005-2006,” Review of Industrial Organization 29: 305–326 • Bushnell, J., Mansur, E., and Saravia, C. (October, 2007) “Vertical Arrangements, Market Structure, and Competition: An Analysis of Restructured U.S. Electricity Markets,” NBER Working Paper 13507 • Gilbert, R. and Newberry, D., “Analytical Screens for Electricity Mergers,” forthcoming, Review of Industrial Organization. • Klemperer P. and Meyer M. (1989) “Supply Function Equilibrium in Oligopoly Under Uncertainty,” Econometrica, 57(6): 1243-77. • Lien, J. (2000) “Forward Contracts and the Curse of Market Power,” University of Maryland Working Paper. • Wolak, F. (2000) “An Empirical Analysis of the Impact of Hedge Contracts on Bidding Behavior in a Competitive Electricity Market,” International Economic Journal, 14(2), 1–40. • United States v. Exelon Corporation and Public Services Enterprise Group, Inc.: Competitive Impact Statement (available at www. usdoj.gov/atr)