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From Enron with love: imperfect competition and the boom-bust cycle April 2015 Thomas-Olivier Léautier

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2 Main messages The “standard” model assumes perfect markets. In reality of course, markets are imperfect Short-term market manipulation is the first concern. Since regulators cannot rely on simple analysis, intrusive controls are implemented Long-term underinvestment is the second concern. In practice, boom-bust cycles are more likely

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3 Optimal retail price and capacity – price responsive demand Price (€/MWh) Capacity (MW) On-peak price covers capital (and variable) costs Off-peak price covers variable cost Optimal capacity: expected marginal operating profit on-peak equals marginal capital cost c K P(Q,t) Source: Boiteux (1949)

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Implementation of optimal pricing 4 Price (€/MWh) Hours c On-peak marginal profit equal to marginal cost of capacity, around €/MW-year For example, price at €/MWh for 60 hours per year on average Source: Boiteux (1949)

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If you do not believe in market power … 5

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What is the right level of spikes? 6

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7 Main messages The “standard” model assumes perfect markets. In reality of course, markets are imperfect Short-term market manipulation is the first concern. Since regulators cannot rely on simple analysis, intrusive controls are implemented Long-term underinvestment is the second concern. In practice, boom-bust cycles are more likely

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Price-quantity equilibrium with market power Price (€/MWh) Quantity (MWh) When demand is very close to supply, price exceeds variable cost. Too much? demand imperfect-competition equilibrium competitive equilibrium supply 8

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Profit : € 40 million Profit : € 20 million Strategic supply reduction Price (€ / MWh) Quantity (GWh) demand Price (€ / MWh) Quantity (GWh) supply Perfect competitionImperfect Competition Production decreases and profit increases supply demand

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How can we mitigate market power? Monitoring by regulators ― Concentration ratios, HHI indexes ― Hourly price cost margins De jure or de facto price caps 10

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Price caps create “missing money” Price (€/MWh) Capacity (MW) v Price cap limits market power and creates “missing money” Capacity mechanism restores missing money hence optimal capacity c K* p max 11

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12 Main messages The “standard” model assumes perfect markets. In reality of course, markets are imperfect Short-term market manipulation is the first concern. Since regulators cannot rely on simple analysis, intrusive controls are implemented Long-term underinvestment is the second concern. In practice, boom-bust cycles are more likely

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Strategic supply reduction in Germany? 13

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« Boom-bust » investment cycle until 2009 … Source : EIA (2009), Tables 8.11a &

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Growth was expected … but interrupted 15 Evolution of electricity supplied EU 28, GWh Source: Eurostat stics stics

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Meanwhile renewables capacity grew rapidly 16 Electricity capacity, EU 28, GW Source: Eurostat Massive capacity shutdown in Europe

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Concluding observations: energy-only markets are imperfect « Energy only » markets are prone to ― boom-bust cycles ― risk of unvoluntary curtailment ― potential market manipulations … but they produce strong price signal, which rewards operational excellence and demand response, hence dampens the above effects 17

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…. while capacity mechanisms lead to Adequate capacity level, and … Race for subsidies during the design phase Potentially weak price signal, hence lower incentives for operational performance and demand response Political interference and discretion in rules setting …. Hence higher uncertainty for the industry 18

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