Transcript slides

Regulating Monopolies
in a Small Economy
Lessons for the New Zealand Electricity Supply Industry
Frank A. Wolak
Director, Program on Energy and Sustainable Development
Professor, Department of Economics
Stanford University
Stanford, CA 94305-6072
[email protected]
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
– 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):
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
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
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
• Market mechanism to set prices for retail electricity
and determine which retailers sell electricity to final
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
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
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
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
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
Optimal Market Design
• Proposed objective function for market
– Lowest annual average retail price of electricity
consistent with long-term financial viability of
– 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
Necessity of Market Design
• Most markets do not require explicit market design
– 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?
Necessity of Market Design
• Physical network required to deliver electricity
– Despite Nikola Tesla’s attempts, cannot beam electricity to final
– 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
– To set prices charged for use of transmission and distribution networks
Market Design Challenges for
Wholesale Market Regime
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
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
– 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, RegulatorUtility Interaction,” available on web-site.
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.
Regulated versus Market Pricing
• Major problem with regulation
– Firm usually knows its technological capabilities
and the demand that it faces better than the
– 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
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
– 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
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
• 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
• 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
Regulated Monopoly
• Historical Benefits
– Economies to scale in generation of electricity
• Average cost of generation declines as total output
– 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
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
Pricing Under Competition Versus Regulation
Pcomp > Preg = A/Qd
TRCompetition = A + B
TRRegulation = A
Prices Under Competition versus Regulation
If A < B, then competition allows consumers to pay less
If MCreg > MCcomp then competition implies lower costs
TRRegulation = B + C + D
TRCompetition = A + C + D
TCRegulation = B + C + D
TCCompetition = C
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
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
Using the Theory of Market Design to
Improve Wholesale Market
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
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)
Residual Demand Curve faced by Firm
DR(p)=Q - SO(p)
Calculation of residual demand curve:
offers of all generators except Firm A
Calculation of residual demand
curve for Firm A
Calculation of residual demand
curve for Firm A
Bid to Maximize Profits Subject to Residual Demand
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
Bid to Maximize Expected Profits
Derivation of offer curve with
flatter residual demands
Derivation of offer curve with
perfectly elastic residual demand
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
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
Divestiture of Generation Capacity
Change SO(p) from SO1(p) to SO2(p)
DR2(p) = Qd – SO2(p)
DR1(p) = Qd – SO1(p)
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
Payments to Purchaser of Hedge
Contracts by Generators at
Payments to Generator by Purchaser
of Hedge Contracts at
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
Profit-Maximizing Output and Price
With Fixed-Price Forward Contracts
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
DRHigh(p) - QC
DRLow(p) - Qc
QLNContract QHNContract Q
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
– Transmission network configuration determines how many independent
suppliers are able to compete to supply energy at each location in
wholesale market
Engineering Reliability
• Enough transmission capacity so that
– Demand at all locations in network can be met with prespecified 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
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
Lessons for Retail Market
• Symmetric treatment of producers and consumers of
– 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
Benefits of a Price Responsive Demand
Q (p)
DR(p)=Q (p)-SO(p)
DR(p)=QD - SO(p)
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
• 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
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
Challenges that Make Market
Design Problem in New Zealand
Extremely Difficult
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
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
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
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
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 longterm energy contracts more likely to develop with less vertical
What is Next for New Zealand
Wholesale Electricity Market?
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
What is Next for New Zealand?
• Improving regulatory process
– Establish an explicit and publicly observable regulatory
price-setting process for transmission and distribution
– 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
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
– Set risk-adjusted rate of return on capital (r)
– Determine prudency of investment decisions (only
prudent investments are allowed cost recovery in output
– 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
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) –
• Data collection for retailing segment of industry to compute
average retail price which can then be used to assess
competitiveness of retailing segment
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)
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
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
• Higher income consumers should be able to take
actions to reduce bill
– Switch suppliers, install technology to increase flexibility of their
half-hourly demand
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
Vertical (Dis)-Integration?
• Separating generation from retailing would certainly
help, but there are other less extreme regulatory
• 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
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 selfassessment 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
• 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
• 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 at
Bid-Based versus Cost-Based Markets
in Hydro-Dominated Electricity
Supply Industries
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
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
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
• 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
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)
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