Regulating Monopolies in a Small Economy Lessons for the New Zealand Electricity Supply Industry

1. Regulating Monopolies in a Small EconomyLessons 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 wolak@zia.stanford.edu http://www.stanford.edu/~wolak

2. 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 concept • 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):http://www.chapmantripp.com/news/Pages/Do-we-still-need-a-Commerce-Commission.aspx

3. 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

4. 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

5. 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 energy • Market mechanism to set prices for retail electricity and determine which retailers sell electricity to final consumers

6. 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

7. 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

8. 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 implications

9. 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

10. 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

11. Optimal Market Design • Proposed objective function for market designer • Lowest annual average retail price of electricity consistent with long-term financial viability of industry • 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

12. Necessity of Market Design • Most markets do not require explicit market design process • 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?

13. Necessity of Market Design • Physical network required to deliver electricity • Despite Nikola Tesla’s attempts, cannot beam electricity to final customers • 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 networks • To set prices charged for use of transmission and distribution networks

14. Market Design Challenges for Wholesale Market Regime

15. 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

16. 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 production • Firm maximize expected profits subject to regulatory process used to set prices may not lead to least cost production • Wolak (1994) “An EconometicAnalysis of the Asymmetric Information, Regulator-Utility Interaction,” available on web-site.

17. 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.

18. Regulated versus Market Pricing • Major problem with regulation • Firm usually knows its technological capabilities and the demand that it faces better than the regulator • 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 service

19. 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 assets • 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

20. 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 industry • 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 production • 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 pricing

21. Regulated Monopoly • Historical Benefits • Economies to scale in generation of electricity • Average cost of generation declines as total output increases • 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

22. 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

23. Pricing Under Competition Versus Regulation Pcomp > Preg = A/Qd

24. Price TRRegulation = B + C + D TRCompetition = A + C + D MCRegulated B MCCompetition PCompetition A C QCompetition Quantity Prices Under Competition versus Regulation If A < B, then competition allows consumers to pay less If MCreg > MCcomp then competition implies lower costs TCRegulation = B + C + D TCCompetition = C D

25. 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

26. 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

27. Using the Theory of Market Design to Improve Wholesale Market Performance

28. 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

29. 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)

30. Residual Demand Curve faced by Firm

31. Calculation of residual demand curve: offers of all generators except Firm A

32. Calculation of residual demand curve for Firm A

33. Calculation of residual demand curve for Firm A

34. Bid to Maximize Profits Subject to Residual Demand

35. 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

36. Bid to Maximize Expected Profits

37. Derivation of offer curve withflatter residual demands

38. Derivation of offer curve withperfectly elastic residual demand

39. 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

40. 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

41. Divestiture of Generation CapacityChange SO(p) from SO1(p) to SO2(p) Price Price DR2(p) = Qd – SO2(p) SO1(p) SO2(p) pmax DR1(p) = Qd – SO1(p) DR1(pmax) Quantity Quantity Qd

42. 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

43. 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 perspective.

44. 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

45. SNC(p) DRHigh(p) - QC PHNContract SC(p) PLNContract PHContract DRLow(p) - Qc DRHigh(p) PLContract DRLow(p) QLContract QHContract QLNContract QHNContract Profit-Maximizing Bidding With QC > 0 and QC = 0 (For Simplicity Assume MC = 0) Expected Profit-Maximizing Bidding With QC > 0 and QC = 0 (For Simplicity Assume MC = 0)

46. 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 market • Transmission network configuration determines how many independent suppliers are able to compete to supply energy at each location in wholesale market

47. Engineering Reliability • Enough transmission capacity so that • Demand at all locations in network can be met with pre-specified 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

48. 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

49. Lessons for Retail Market • Symmetric treatment of producers and consumers of electricity • 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

50. Benefits of a Price Responsive Demand Price-responsive aggregate demand flattens residual demand distribution faced by all suppliers