Market Power in Electricity: Hydro and Thermal Plants

1. ECON 4925 Autumn 2007Electricity EconomicsLecture 10 Lecturer: Finn R. Førsund Market power

2. Hydro and thermal • Thermal plants aggregated by merit order to a convex group marginal cost function • Total capacity is limited • Static problem: no start-up costs, no ramping constraints or minimum time on – off • Hydro power plants aggregated to a single plant Market power

3. Monopoly problem with hydo and thermal plants Market power

4. Solving the optimisation problem • The Lagrangian function (eliminating total consumption) Market power

5. Solving the optimisation problem, cont. • The Kuhn – Tucker conditions Market power

6. Interpreting the optimality conditions • Assumption: both hydro and thermal capacity is used • Flexibility-corrected price equal to water value equal to marginal thermal costs (plus shadow value on the capacity constraint) • Same amount of thermal capacity used in each period Market power

7. Monopoly and extended bath-tub Period 1 Period 2 p2M p1M λM c’ c’ a c A D C B d Hydro energy Thermal extension Market power

8. Hydro with competitive fringe • Thermal fringe modelled by a convex marginal cost function with limited capacity • The fringe is a price taker and sets market price equal to marginal cost • The dominant hydro firm must take fringe reaction into consideration • Market power is reduced due to the fringe • Conditional marginal revenue curve closer to demand curve due to market share less than 1 and fringe quantity adjustment Market power

9. The optimisation problem of the dominant hydro firm Market power

10. The reaction of the competitive fringe • Finding the reaction of the fringe to the quantity of the dominant firm • Solving for thermal output as a function of hydro output Market power

11. The reaction of the competitive fringe, cont • Determining the sign of the reaction function • Differentiating the behavioural condition Market power

12. Solving the optimisation problem of the dominant hydro firm • The Lagrangian function • The Kuhn – Tucker conditions Market power

13. Interpretations • Signing of the expression (1 + detTh/detH) Market power

14. Interpretations, cont. • Decomposition of conditional marginal revenue • Conditional marginal revenue curve closer to demand curve due to • Market share less than 1 • Fringe reaction of increasing output when price increases Market power

15. A constraint on fringe thermal capacity • Advantage for the dominant firm when fringe capacity constraint is biting • Limit on the fringe quantity reaction • Fringe response Market power

16. The leader – follower game Period 1 Period 2 p2 θ2 p1 c’ c’ λ λ A B C D E Hydro energy Thermal fringe Market power

17. Extentions • Hydro as competitive fringe • Hydro fringe can release all water just in one period, may restrict market power further • Oligopoly game between hydro producers • Essentially a dynamic game, reduces the possibilities of strategic shifting of water • Quite complex to find solutions to dynamic gaming • Uncertainty • Future water values become stochastic variables, system must avoid overflow or going dry, qualitatively the same problem for social planner and monopoly Market power

18. Conclusions • Hydro monopoly shifts water from relatively inelastic periods to elastic ones • May be difficult to detect because variable cost is zero, only alternative value of water is variable cost and not readily observable • Reservoir constraints, production constraints, etc. reduce the impact of market power • Competitive fringe may block use of market power • Fear of hydro market power exaggerated? Market power