New research published in the April 2007 Economic Journal examines the behaviour of National Power and PowerGen, the two largest generators in the England and Wales electricity wholesale market in the late 1990s. The study by Professor Andrew Sweeting has important implications for the design and analysis of electricity markets in many countries today:
- Despite falling fuel costs and reduced market concentration, prices were persistently high. What”s more, each generator could have profitably increased its output by about 20%. This may have happened because of tacit collusion, with each generator reasoning that it should not increase output today because this might induce other generators to increase their output tomorrow.
- Tacit collusion, which raises prices, may be a problem even in markets that are not highly concentrated. For example, by 2000, the HHI (a standard measure of market concentration) in the England and Wales market was below 1,800, the level used in antitrust proceedings to identify high concentration.
- Widely used policies, such as enforced plant divestiture and the promotion of entry by independent power producers, may not serve to reduce market power in the short run. So the Competition Commission”s reasoning may have been flawed in deciding that generator licenses did not need to prohibit the abuse of market power in 2001.
- The details of market design may matter. In particular, features that make tacit collusion more difficult to sustain may tend to reduce prices. There is evidence that the England and Wales electricity market became significantly more competitive when the Pool ceased to exist in March 2001 and was replaced by a structure that was less transparent.
- An alternative interpretation of the results is that the generators restricted output in order to raise prices in the market for long-term hedging contracts by affecting buyers” expectations of future spot market prices. This interpretation could only make sense under very particular assumptions about how buyers form their beliefs. But if this interpretation is correct, then it would also have important implications because the existence of long-term contracts has been widely viewed as softening market power.
The period 1995-2000 was characterised by persistently high prices and mark-ups, in spite of falling fuel costs and reduced market concentration. This pattern provides a challenge for the kind of static models usually used to analyses electricity markets because these models would have predicted that prices and mark-ups should have fallen.
This study provides further evidence against these models by examining the bidding behaviour of the two largest generators, finding significant deviations from normal, static profit-maximising behaviour. In particular, each generator could have profitably increased its output by about 20% under a variety of assumptions about their costs and contract cover.
What can explain this finding? The most obvious explanation is that National Power and PowerGen, and possibly other generators, were engaged in some form of partial tacit collusion. Under tacit collusion, a generator might reason that it should not increase output today because this might induce other generators to increase their output tomorrow.
As was recognised at the time, various features of the Pool, including daily bidding with readily available information on other generators’ bids, were conducive to tacit collusion.
”Market Power in the England and Wales Wholesale Electricity Market 1995-2000” by Andrew Sweeting is published in the April 2007 issue of the Economic Journal.
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