Lessons learned from Nordic electricity market liberalization: Competition and regulatory issues

1
Lessons learned from Nordic electricity market
liberalization Competition and regulatory issues

• Einar Hope
• Norwegian School of Economics and Business
  Administration
• ETH Zürich 03.04.08

2
Overview

• Some lessons from the Nordic, European and US
  power market reforms
• Special characteristics of electricity in market
  terms
• Market design of organised power markets
• Some competition issues
• Potential sources of potential market power
• Market design of retail markets and some retail
  competition issues
• Regulation of network infrastructure. Some
  regulatory issues

3
(No Transcript)
4
Some characteristics of electricity as a commodity

• Multi-dimensional product energy(kWh),
  capacity(kW), voltage, frequency, security of
  supply, location etc).
• Demand elasticity price, income (short run -
  long run)
• Derived demand. Low energy cost in relation to
  total cost
• Seasonal variations year, day. Load curves
• Capacity adjustments. Hydro, thermal
• Long term investments. Generation, network
• Self service system

5
Characteristics of electricity markets

• Electricity cannot be stored (hydro), homogeneous
  commodity
• Instantaneous balancing of supply and demand by
  system operator
• Very low short run elasticity of demand also
  long run derived demand price signals with a
  lag, limited real-time pricing. Also low short
  run supply elasticity
• Capital intensive, lumpy, irreversible and
  durable investment fixed cost, sunk cost. Long
  lead times
• Capacity constraints in transmission the network
  as a market
• Market power issues deriving from characteristics
  and properties of electricity

6

• Figure Industry cost (supply) curve. The rent
  concept

7

• Figure Industry cost curve for energy. Merit
  order system

8

• Figure Marginal cost in a hydro power system

9
Welfare analysis economic efficiency

• Economic efficiency concepts
• Static efficiency
• Technical efficiency. Productive efficiency
• Allocative efficiency
• X-efficiency (inefficiency)
• Dynamic efficiency
• Technological change
• Product innovation, etc
• Rent seeking
• Decomposition of efficiency concepts.

10
Performance criteria Efficiency dimensions

• Static efficiency (operation)
• Cost efficiency
• Optimal use of total production and grid capacity
• Dynamic efficiency (investment/innovation)
• Optimal dimensioning of production and grid
  capacity
• Introduction of new technology and products in
  the value chain (incentives for innovation)
• Facilitating market integration spacially,
  across energies, and in relation to other
  products/sectors
• Capacity enhancing investment versus investment
  in flexibility
• Security of supply reliability

11

• Figure . Decomposition of efficiency concepts

12
Economic efficiency and market failure

• Sources of market failure
• Public goods
• External effects in production and consumption
• Market imperfections
• Economies of scale (natural monopoly)
• Monopolisation
• Lacking markets
• Competition monopoly regulations
• Imperfect information asymmetric information
• Uncertainty
• Market failure in energy markets

13
Some lessons from the reform of the electricity
industry

• The Energy Act of 1990 in Norway Establishing
  electricity markets, common carriage, vertical
  separation, regulatory system
• A common Norwegian-Swedish market from 1996. An
  integrated Nordic market from 2001
• Considerable gains from deregulation - still a
  considerable potential, especially in the grid
  and from further integration of energy markets
• Reduction in the general price level of
  electricity - greater volatility of prices

14
(Cont)

• Greater flexibility on the demand side and change
  of consumer behaviour New contract forms, price
  competition, change of supplier, price
  information systems, risk hedging facilities,
  customer focus
• Entry of new players in the markets Brokers,
  traders, clearing companies, retail chains,
  petroleum companies, financial analysts,
  international energy companies
• New organisational forms Co-operative and
  outsourcing arrangements, e.g for power
  purchasing, invoicing, metering etc. Concern
  model, horizontal and vertical integration to
  end-consumers, separation and unbundling of
  competitive and monopoly functions

15
(Cont)

• Ownership structure - cross-ownership,
  privatisation
• Long gestation period for competition in
  retailing
• Inertia and opposition to change from suppliers
  Ownership structure, production orientation,
  market power, political influence. Consumer
  inertia/local loyalties, inexperienced consumers
  operating in new markets
• Primitive risk hedging facilities and contracts
  for small consumers (households) - but developing
• Regulatory lag - regulatory uncertainties

16
Design of organized power markets

• Organized power markets operated by NordPool
• Elspot (physical spot market deliveries)
• Eltermin (futures and forward contracts)
• Elbas (thermal power adjustment markets)
• Eloptions (European and Asian power options)
• Design and operation of green electricity
  markets
• Markets operated by grid operators
• Regulation Market (Norway/Statnett) capacity
  market balance market between real and planned
  exchange in the delivery phase on short notice
  (15 min)

17
cont

• Elspot daily trading for delivery next day for
  each of 24 hours. Price and quantity by noon -
  market contracts by 2.30 p.m., based on
  equilibrium price of aggregate supply and demand
  schedules (system price)
• Eltermin Futures market for hedging of power
  contracts up to three years ahead. Daily market
  settlement of the difference between system spot
  price and contract price. For forward contracts
  settlement only in the delivery week - no daily
  settlement

18
cont

• Elbas market for adjusting imbalances for
  thermal producers in Finland and Sweden after
  completing their Elspot trade. Continuous trading
  for single hours up to two hours prior to
  delivery
• Clearing functions Power Clearing System and
  Nordic Electricity Clearing (NEC operated by
  NordPool) of spot and futures contracts. Clearing
  also of bilateral contracts as of 1998.
• Some 280 customers trading at NordPool (power
  producers, distributors, industrial companies,
  large retail customers, brokers, traders etc.)

19
cont

• NordPool is a non-mandatory pool around 70 of
  total traded volume through organized markets
  liquidity and efficiency?
• On the whole a successful market reform
  considerable efficiency gains, integration
  effects and greater flexibility for consumers

20
(No Transcript)
21
(No Transcript)
22
(No Transcript)
23
(No Transcript)
24
(No Transcript)
25
(No Transcript)
26
What went wrong in California?

• Electricity industry before regulatory reform in
  April 1998
• Three large investor-owned utilities (IOUs)
• Vertically integrated into generation,
  transmission and distribution
• Significant out-of region energy needed to serve
  in-state demand. (Ca. 25)
• Retail electricity rates regulated by California
  Public Utilities Commission (CPUC)
• Wholesale prices and transmission tariffs
  regulated by Federal Energy Regulatory Commission
  (FERC)

27
Factors contributing to crisis

• Small amount of new capacity built in California
  during 90s, and also in surrounding states
• Higher natural gas prices
• Forced outages since summer of 2000
• Price inelastic wholesale demand
• Retail price freeze
• Few consumers face real-time price
• Price cap on wholesale price
• Regulatory differences between federal and state
  (FERC and CPUC)

28
Competition issues Market power

• Definition of market power
• The power to profitably raise the market price
  above the competitive level
• Observations on market power
• Potential market power may or may not be
  exercised
• The Lerner index (price marginal cost/price) is
  a measure of exercised market power
• Several measurement problems

29
Potential sources of potential market power

• Definition of relevant market Nordic, national,
  regional, local. Organized markets and total
  market, including bilateral contracts. Importance
  of transmission capacity constraints.
• Measuring market concentration Vattenfall ca 50
  market share of Swedish market 20-25 of Nordic
  market. Many suppliers - low horizontal market
  concentration
• Horizontal and vertical integration strengthened
  market position, cross-subsidization, locking-in
  of customers, price discrimination

30
cont

• Composition of energy system hydro and thermal.
  Market power in hydro systems. Norway only hydro.
  Share of hydro power in the Nordic system around
  50
• Demand variations daily and seasonal peak
  demand summer-winter variations
• Ownership and incentives public ownership,
  cross-ownership, concentration
• Capacity constraints in generation
  underinvestment?

31
cont

• Capacity constraints in transmission and handling
  of constraints
• Asymmetric information large and small players?
• Collusion tacit or coordinated through
  transparent markets?
• Entry conditions and behaviour potential
  competition as disciplining factor
• Enforcement of competition policy in electricity
  markets and design of regulatory system for
  natural monopolies. Relationship between
  competition policy and sector-specific regulatory
  agencies

32
Market power in wholesale markets

• As generation and load have to balance in real
  time, pivotal generators have very significant
  potential market power
• Pivotal generators need not be big (in terms of
  annual production or market share)
• But big generators are pivotal more often than
  small generators
• Thus there is a positive relation between
  concentration and potential market power in
  wholesale electricity markets

33
Market power mitigation in wholesale markets

• Splitting of major incumbents and reduced
  barriers to entry
• More players in a given market
• Integration of previously separated local,
  regional or national markets
• Larger market for a given set of players. (Key
  issue interconnector/transmission capacity and
  pricing
• Forward contracting
• More markets for a given set of players

34
Best practice, Nordic countries, Wholesale

• Market integration and forward contracting No
  significant exercise of market power documented
• Features of the Nordic market
• Interconnector/transmission capacity sufficient
  for regional price equalisation most of the time
  (?)
• Degree of concentration relatively low
• Stringent market rules make relevant information
  available for all market participants
• Significant share of hydro power

35
Some retail market developments

• A very transparent market
• An increase in the number of suppliers with
  external offers, i.e. outside their
  concessionary grid area
• Restructuring of the retail trade market through
  mergers and acquisitions increased regional
  concentration. Still a considerable number of
  players. New players entering the market
  (specialized traders, oil companies, electric
  appliance chains etc). Some problems with
  unserious entrants.

36
cont

• Product innovations, mainly through new contracts
• Price discrimination between small and large
  retail customers. Some suppliers now charge an
  administration fee for small customers to
  recover some of the switching cost and shift
  competition to large customers by giving special
  price offers
• Somewhat reduced price spread over time
• Retail markets are still national within the
  Nordic market - no cross-border competition yet

37
Some retail competition issues

• Sufficient mobility of retail customers
  (switching) to sustain effective competition?
• Incentive for switching from reduced price
  spread?
• Competition or coordination of prices of
  suppliers from transparency and frequent exchange
  of price information (market contact)?
• Distribution of transaction costs between
  suppliers and end-users?
• Increased vertical integration in the value
  chain. Implications for competition?

38
cont

• Bundling of products from horizontal integration
  to other energy forms (gas and district heating),
  plus ICT products?
• Risk hedging contracts - potential for improved
  contracts for households. Locking-in effects of
  risk contracts and long-term contracts?
• Incentive effects of standardized load profile
  measurement and charging of customers?
• Lowering of grid user prices through more
  efficient and stronger enforced regulatory regimes

39
Market power in Nordic retail markets

• Low barriers to entry suggest that retail markets
  are contestable
• High actual and perceived switching costs may
  protect incumbents and give them market power
• High retail market concentration in Sweden and
  Denmark

40
The process of benchmarking

• Benchmarking one of several possible methods or
  instruments for a regulator or a firm to assess
  the relative performance standard compared to a
  set of selected observations.
• Steps in a benchmarking analysis
• Identify the group of units (firms) for
  comparison demarcation of functions
• Identify range of potential methodologies
• Identify outcome equivalent to best practice
• Collect data on a consistent basis
• Conduct analysis. Compare own performance with
  best practice
• Plan and implement improvements. Assess outcome
  and implement corrective measures
• Examples of benchmarking from SESSA

41
(No Transcript)
42
(No Transcript)
43
(No Transcript)
44
(No Transcript)
45
(No Transcript)
46
(No Transcript)
47
(No Transcript)
48
(No Transcript)
49
(No Transcript)
50
(No Transcript)
51
(No Transcript)
52
(No Transcript)
53
Investment in power markets reference to the
Nordic market

• Experience mainly with the operation of a market
  based system within a given capacity. Will the
  market pass the optimal investment test?
• Large excess capacity in the former system.
  Approaching/exceeding binding capacity
  constraints in production and transmission.
• Different principles for the handling of capacity
  constraints among the Nordic countries. Need for
  harmonization.
• Consider investments in the whole value chain
  more focus on investment in the end-use part?

54
Types of regulation

• Self regulation
• Direct regulation
• Incentive regulation
• --------------------------------------------------
  ---------
• Regulation and competition
• Regulation of one-product production and full
  information
• Regulation of multi-product production and
  asymmetric information

55
Regulation of natural monopoly

• Defining natural monopoly
• Demarcation of functions
• Extent of n.m.
• Organisation of n.m.
• Pricing of services
• Operation of system - dimensioning of capacity
  (investments)
• Regulation of n.m.

56
Regulatory mechanisms (models)

• Rate of return regulation
• Marginal cost regulation
• Full cost regulation
• Price-cap regulation
• Yardstick regulation (competition)
• Price discrimination

57
(No Transcript)
58
(No Transcript)
59
(No Transcript)
60
(No Transcript)
61
Network regulation in Norway

• Rate of return regulation until 1997. Then
  revenue-cap regulation (income frame), but with
  elements of RoR and yardstick regulation
• Co-ordinated annual data collection. Validation
• DEA used to estimate efficiency frontier and
  calculate individual efficiency factors
• 190 distribution units, 30 regional grid units,
  pluss Statnett
• Review of regulatory model and experience. New
  model envisaged for 2007-12.
• Regulatory model in view of network
  reorganization, a Nordic integrated electricity
  market, the network as an instrument for a market
  based system, harmonizing regulatory rules and
  principles, etc