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This training program provides an overview of market monitoring targets, market power issues, mitigation strategies, and the use of indices for market monitoring. Participants will also learn from international experiences in power market surveillance.
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Pakistan’s Power Market Transition (PPMT) ProjectTraining on Power Markets Market Surveillance
Contents • Review of Market Monitoring Targets • Market Power Issues • Market Power Mitigation • Use of Indices for Market Monitoring • International Experiences
Contents • Review of Market Monitoring Targets • Market Power Issues • Market Power Mitigation • Use of Indices for Market Monitoring • International Experiences
Objectives of Market Monitoring Activities • Monitoring the efficiency and performance of the market (short term & long term) including identifying flaws in market rules that create inefficient incentives • Detection of incorrect use of the market rules • Detection of market abuses and gaming. • Detection of the potential for or use of market power
Market Monitoring Activities • Collect information on market functioning • Process the information • Identify anomalous- undesirable behavior • Identify causes amongst: • Market rules and procedures • Inappropriate use of rules • Misconduct of market participants • External or non-controllable variables • Recommend amendments • Recommend-enforce penalizations
Who Perform the Monitoring Function? • Regulator probably has primary responsibility for MM • issues guidelines, reports • working in close cooperation with SO/MO/TSO/PX and explaining findings to stakeholders • Market monitoring units (MMU) within SO, MO, PX • internal or external • academics (as in Netherlands initially) • specialized consultancies (as in some US markets) • Academics/media/consumers can use published data for impartial comment. • Competition authorities • guidelines on how disputes investigated, resolved.
US: Duty to monitor prices (“just and reasonable”) and mitigate market power Ex-ante mitigation measures Strong tradition of publicly available data. Market Monitoring Units are part of an RTO or ISO. Supported by academics and independent consultants FERC Monitoring. EU: Longer term and case-by-case rather than continuous screening. EC Benchmarking Reports and Sector Inquiries Collaboration between national regulatory and competition authorities, Mostly ex-post measures Some regulators lack legal powers to demand information. Recommendation: “Priority action: the setting of a European Market Surveillance Committee Network”. TwoDifferentApproaches
Contents • Review of Market Monitoring Targets • Market Power Issues • Market Power Mitigation • Use of Indices for Market Monitoring
Market Power • Market power detection and mitigation is not the only target of MMU, but probably the most famous • The possibility for exercising market power is perhaps the most critical issue in the development of electricity markets. Recent experiences in many countries as well as academic research show that market power can be exercised more easily in electricity spot power markets than in other commodity markets. • It is easier in electric markets than in other markets due to: • Inelasticity of demand in the short term • Concentrated ownership (few participants) • Limitations in transmission capacity • Non storability • High sunk costs
Market Power • Theory and real world practices show that when a generator does not attempt (or does not can) manipulate prices, the strategy that maximize its profits is to bid they actual opportunity costs, which usually coincides with their variable costs • From the demand side, theory demonstrates that social welfare is maximized when generators bid their actual opportunity cost • However, estimation of opportunity costs is not straightforward: • In case of hydro plants with reservoir, variable costs are nearly zero, but there are opportunity costs linked to store water to release when prices are high. In this case the optimal bid is that which equal the expected benefit to store water with the present benefit to produce immediately, • Thermal plants with fuel take or pay contracts may have an opportunity cost lower than the fuel price, which depends on fuel supply contracts and generators expectations on market evolution • Variable costs include those linked to units start-up, that in turn are partially linked to maintenance practices, • Opportunity costs of marginal units is greater than their variable costs, as the only way they have to recover fixed costs is to get more money that those obtained from the energy market (if they are marginal, their bids set the price, so only can recover variable costs from the market) • Conclusion: it is hard for a third party like the MMU to estimate properly opportunity costs.
Market Power Definitions • Several definitions of market power: • The ability to alter profitably prices away from competitive levels –i.e. those arising from generators bidding their opportunity costs- for a significant period of time • Ability (action) to raise prices above competitive levels (FERC) • If a supplier would profit (in expectation) from the sale of an additional unit, counting only the costs and revenues of that one unit, and the supplier chooses not to sell, it has exercised market power.
MeasuringMarket Power • Concentration indexes to measure market power in energy markets, such as the Herfindahl-Hirschman Index (HHI), capture ability, no incentives or actions of agents. • Lerner Index: Price – Competitive Price can identify market power exercise, but competitive price is hard to obtain • Why HHI is useful? HHI = i %PARTi2 (Price – Competitive Price) Price LI = Average (LI) HHI e
Measuring Market Power • Pivotal indices identifies participants that are necessary to meet the load, and consequently may set the price. • If PIi < 1, participant i is pivotal • Conduct and impact tests: The C&I tests establish criteria for determining whether a generator is economically withholding its capacity and, if so, whether it is increasing the market price (or other payments as AS). The conduct tests consist of comparing a supply bid to a pre-defined threshold (% of reference price). Impact tests are performed when the conduct tests fail, detect whether the specific bids in question increase prices above pre-defined thresholds relative to reference-level bids (Total_capacity – Capac_participant_i) Demand PIi =
Market Power Concepts • Important to differentiate two concepts: • Market Power Potential: Most of the indices used by MM can identify if the market conditions are appropriate to exercise market power, rather to identify if a participant is really doing. • Some indices (HHI, pivotal, etc.) identify the market participants that may have the ability to manipulate prices, no if they are exercising.. • Market Power Exercise: this is different to identify if a participant effectively exercised market power • Lerner index may identify if a participant really manipulated (or attempted to manipulate) prices. However this requires knowledge of the actual variable costs of the participant • Some studies compared the actual prices with those arising of from assuming that participants bid their opportunity costs. Although the approach is right, it is difficult to know which are the participants’ actual opportunity costs
Issues on Market Power • Market Participants Behavior • Competitive: market participants believe/know they can not influence on price, therefore their optimal bid is their actual opportunity cost. • Non competitive: the market participants consider that they can influence on price, and consequently bid prices and quantities that allow them to increase benefits • Unilateral exercises of market power arise through the actions of a single firm, possibly a dominant or pivotal supplier, who has the ability and incentive to raise price or restrict output without the complicity of other firms • Collusion: The agreement of two or more firms to jointly influence on prices with the aim of benefiting • Market power is based on withholding of output. Withholding can be accomplished financially by bidding a high price (aiming that some units are not dispatched), or physically by not bidding at all. • Market power potential is the existence in the market of conditions that facilitates market power exercise. May be: • Structural: ownership concentration, pivotal participants • Arising form market rules, e.g. barriers to entry of new generators
Issues on Market Power • Are both incentive and ability required to demonstrate the existence of market power? • Is it necessary a conceptual distinction between market power ability, exercise of market power, and abuse of market power? • Ability can be measured through HHI, pivotal, etc. • Exercise as choosing not to sell • Abuse as pushing prices % above some threshold • Market power should be mitigated through: • Existence of ability to exercise (i.e., an ex ante approach) • By prosecuting those suspected of having abused market power after the fact (i.e., an ex post approach). • “Workable market power” is a more realistic strategy for a market participant. Under workable market power, price may exceed short-run marginal cost and firms arguably may engage in limited exercises of market power (and prices would exceed short-run competitive levels). The goal is to raise prices below the threshold the triggers mitigation or penalization actions.
Market Power and “Just and Reasonable” Rates – FREC Approach • Facing the prospect of the potential exercise of market power in liberalized wholesale electricity markets, the FERC has the regulatory responsibility, under Section 205 of the Federal Power Act (FPA), to ensure that all rates charged in connection with wholesale power sales and the transmission of electric energy in interstate commerce are just and reasonable. • So FERC has the duty to prevent “excessive pricing” (i.e., the abuse of market power in this context) when it arises, even in energy markets that are subject to competitive interaction. • There is no consensus on the proper definition of “just and reasonable rates”. • Courts have determined that an unjust and unreasonable rate is one that falls outside the zone of reasonableness. That zone excludes rate levels that are “less than compensatory” to producers or “excessive” to consumers • FPA is a regulatory statute and not an antitrust law, so its primary regulatory goal is the attainment of just and reasonable prices, not the preservation of competition itself, which is the essential goal of antitrust laws • So, ensuring just and reasonable prices exceeds the scope of MM, with the exception of cases when “excessive prices” are the result of market power
Consequences of Market Power • Society as a whole sustains losses whenever the market price for a product exceeds, rather than equals, the cost of producing an additional unit of that product. Under these circumstances, buyers pay more for the product than it costs to produce • An exercise of market power results in a product price that exceeds marginal production costs because less output is produced relative to a “perfectly competitive” market, where price equals marginal cost • The social welfare loss attributable to market power is then measured as the difference between what buyers pay (or would be willing to) for the forsaken output and its associated production costs
Contents • Review of Market Monitoring Targets • Market Power Issues • Market Power Mitigation • Use of Indices for Market Monitoring • International Experiences
Intrinsic Difficulties in the Measurement of Market Power • One criterion to measure market power is based on comparing bids in real world with those (theoretical) based on opportunity costs. • As described before, the estimation of opportunity cost by third parties is, in some cases, complicated and subjective, • This is therefore the main challenge to the MMU. • Two approaches: • Ex –ante: control/modify bids of participants with market power potential • Ex –post: identify (roughly) market power exercise, and investigate probable responsible, • In both cases it is necessary to monitor the market functioning, typically through indices
Mitigation Approaches Ex-post Mitigation Approaches General Ex-`ante Participants oriented
Ex – ante General: Price caps and/or Obligation to bid variable costs and/or Obligations to contract Participants oriented Conduct tests Control of HHI in auctions Tri-pivotal tests Depending of tests results, bid caps are imposed Ex –post Systematic follow-up of market behavior through indices When indices are above threshold, investigations are launched Investigations can be initiated by MMU, regulator or competence authorities MMU, based on investigation results, can recommend penalizations Characteristic of the two Approaches
Market Power Mitigation • Structural solutions. The example is to mandate or encourage the divestiture of the dominant generator(s), encouraging new market participants by reducing or removing barriers to entry. • Barriers may include license conditions, generation site permits, and non-discriminatory access to the transmission network. • Expansion of the transmission system is another means of decreasing concentration of generation by expanding the geographic market over which suppliers are competing. • On the demand side, various means of increasing price responsiveness of electricity customers is also seen as a promising way of reducing market power. • Where divestiture seems to be institutionally or politically difficult, the right to use electricity generation units can be auctioned off rather than ownership of the assets themselves (e.g. Virtual Power Plant auctions in The Netherlands, France and Spain). In general, the encouragement of forward contracting is regarded as an important means of reducing market power.
Market Power Mitigation • Regulatory solutions. Among them is the imposition of system constraints (e.g. market-price caps), requirement imposed to the dominant generators to sell a certain amount of their capacity under long-term contracts at a pre-negotiated or regulated rate. • Where governments have privatized generation companies they have frequently provided them with so-called ‘vesting’ contracts as a transitional tool in the development of competitive electricity markets. In other cases, governments may provide private generation companies with Competition Transition Contracts to allow them to recover stranded costs incurred under a previous cost-based regulatory regime (as it was done in Spain). • Market rules solutions aimed at the actual operations or decisions of the generators in electricity markets. The most important are caps on unit-specific bidding. These are often regarded as the most heavy-handed form of regulation and most liable to have unintended undesirable side effects.
Market Power Mitigation • In either case, the choice of specific mitigation regimes (as well as the screening methods that trigger mitigation) has much to do with policymakers’ beliefs about two key issues: • What is the likelihood of the false identification of market power abuse when it does not exist (“false positive” or “type I” error)? • What is the possibility that the enforcement regime will fail to detect market power abuse, or fail to do so in a timely manner, and what will be the economic and political cost of this failure? (“false negative” or “type II error”) • In order to choose the optimal mitigation regime, policymakers need to develop “loss functions” that represent their assessment of the likelihood of false positives or false negatives and the associated costs of such errors. • These costs should also consider the costs of enforcement regimes, like monitoring, evaluating, and applying mitigating measures.
Contents • Review of Market Monitoring Targets • Market Power Issues • Market Power Mitigation • Use of Indices for Market Monitoring • International Experiences
Data Collection and IndicesPreparation • In order to determine market performance and eventual market power abuse, special indices were developed. • Most market power indices based on company’s conduct typically rely on the assumption of rationality: if we assume companies are profit-maximizing, then we can assume that observed company conduct which alters prices is profitable for the company. • There is no universally accepted set of market monitoring statistics and indices. In practice there is a large set of data and indices that are monitored on varying time scales. The following banding of indices by groups serves as a useful guide: • Market Prices, Demand and System Conditions • Market Structure Indices • Supplier Indices and Analysis • Market Performance Indices and Analysis
UsingIndicesfor Diagnosis • With experience in the indices that result for specific behaviors and outcomes in the market of Market Participants, it may be possible to establish for some types of indices the levels at which the functioning of the market or the conduct of a type of Market Participant is considered, in general terms, acceptable. • In such cases, thresholds may be established for those indices, which will serve as a screen or reference level. The combination of an index with one or more thresholds will facilitate further identifying anomalous conditions or behaviors that require further assessment. • There is a lack of established benchmarks for market monitoring indices. • While some monitoring indices have become standards and can be used under different market design and sector structure, the thresholds of these indices are in some ways unique, and do depend on market structure, generation and system conditions. • Effective thresholds can only be identified with experience and the results of the actual operation of the market. An effective and useful threshold can only be defined with experience in the particular market and sector where it will be used.
StructuralIndices The raw data in this area consist of information on generator market shares and on the price responsiveness of demand. That information can then be analysed to give the pivotal supplier index and residual supply index. Structural indices are calculated for specific markets (a product and a geographic area).
MeasuringMarket Power • Pivotal indices identifies participants that are necessary to meet the load, and consequently may set the price. • If PIi < 1, participant i is pivotal • Conduct and impact tests: The C&I tests establish criteria for determining whether a generator is economically withholding its capacity and, if so, whether it is increasing the market price (or other payments as AS). The conduct tests consist of comparing a supply bid to a pre-defined threshold (% of reference price). Impact tests are performed when the conduct tests fail, detect whether the specific bids in question increase prices above pre-defined thresholds relative to reference-level bids (Total_capacity – Capac_participant_i) Demand PIi =
Models to Detect Market Power Exercise • Market simulation models: reproduces the clearing process performed by the MO, assuming competitive behaviour of the participants: • As distinct from indices, simulation models aim at simulation of expected market outcome using as an input data actual proxies of generators opportunity costs, market structure and market design. The aim is the further (ex-post) comparison with the market results. • Because on uncertainty in opportunity costs, only are useful when the actual market prices are substantially greater than those calculated with the simulation, i.e. above the reasonable error in opportunity costs calculation
Models to Detect Market Power Exercise • Rational behaviour models: attempt to identify strategies of market participants to maximise profits. To influence on prices, maximising profits can be achieved by alternative strategies. • Some academics have developed market power (oligopoly) simulation models, which assumes some stylised behaviour of market participants: • Nash-Cournot: Participants choose a level of output (i.e. volume bided), and they base that choice on the assumption that the choices of other suppliers’ will not be affected by their decision, finding an equilibrium where prices are above competitive level, • Bertrand: participants bid price above marginal costs. Nash-Cournot may be exercised bidding high the capacity that is wished to withdraw, • Supply function: price-quantity bid functions, rather than the inflexible quantity bid, setting price above marginal cost, • Quantity leadership models (Stackelberg): there are a few leader firms that anticipate the reaction of rest of the participants (followers). The leader optimizes strategy, and then followers optimize taking leaders’ decisions as a fixed input.
Models to Detect Market Power Exercise • Behavioural models may be useful to identify market power potential and impact of mitigation measures. For instance to estimate maximum prices that can be achieved is participants bids a la Cournot. An how much prices would decrease if participants are forced to sell generation assets, • But not useful to assess exercise of market power, as it is not possible to identify the market power exercise “style” of participants (which probably does not follow the stylised behaviour models)
Reporting • The Market Surveillance entity issues periodic reports on the market evolution • The main components of the reports are the evolution of the indices • Information on specific investigations are not public until the end of the process, and depending on results.
Sanctions • Sanctions can be applied by the ISO or MO, Regulatory Agency or Courts, depending on the severity of the breach to rules: • Warn or admonish • Fines • Transitory suspension of the participant • Permanent suspension of the participant, cancellation of the license.
Contents • Review of Market Monitoring Targets • Market Power Issues • Market Power Mitigation • Use of Indices for Market Monitoring • International Experiences
International Experience on Mitigation • Several USA ISOs and RTOs have adopted ex-ante mitigation measures. Two substantially different ex ante mitigation approaches arise: • Structural tests (PJM, CAISO, ERCOT): impose automatic mitigation based on structural conditions (e.g., existence of jointly “pivotal” suppliers) that are consistent with the ability to exercise market power. • Conduct-and-impact tests (NYISO, ISO-NE, and MISO): Conduct-and-impact tests impose mitigation only if a firm’s actual bidding behavior is inconsistent with a competitive benchmark and has a material impact on market-clearing prices • The conduct-and-impact approach to analyzing market power is to directly assess supplier conduct and its impact on market prices, such as bidding above cost or engaging in physical and/or economic withholding of output. • It is important to note that ex-ante mitigation measures leads to modification of the bids presented by the participants, but not to penalties. The result of failing an impact and conduct test is to automatically set the bids to reference levels.
International Experience on Mitigation • EU, Philippines and Latin America are oriented to ex-post measures. Although UK made repeated but unsuccessful calls for implementation of ex ante mitigation measures. • Therefore ex-post mitigation measures rely on investigations and, if the presumed participant is declared guilty of market abuse, different types of penalties. Penalties differs according with the country, and usually the regulator of competition authority has available a wide range of remedies. Examples: • UK: Market power mitigation relies exclusively on ex post enforcement actions. The exercise of market power by electricity generators is controlled only by the standard framework of the UK’s competition law • NordPool: There are no price caps applied to the energy market. The actual monitoring of the day-ahead physical energy market is generally designed to react to observed market abuses, with Nord Pool having the ability to fine participants for exercises of market manipulation. • Spain: the competition authority can impose fines to companies declared guilty of exercising market power or prices manipulation. The fine is related with the expected damage produced by the abuse.
