1. Regulating Monopolies in a Small Economy Lessons 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

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):

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

38. Derivation of offer curve with perfectly 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 Capacity Change 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) Qd
Quantity
DR1(pmax)
Quantity

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

51. Lessons for Distribution Network
Active participation of final demand in wholesale market requires interval metering
Without interval metering can only sell electricity based on monthly average price
Conventional meters only measure total monthly consumption of electricity
Read meter at beginning of month and end of month, monthly consumption is difference between two meter reads
Firms have limited idea who in a given customer class is more expensive to serve in terms of wholesale energy costs
With interval meters prices can differ across all hours of the month (hours of the day)*(Days of the Month),
p(h,d) = price for hour h of day d
Up to 744 prices per month

52. Universal Interval Metering
Cost is not a barrier to ubiquitous interval metering
In US, cost savings on manual meter reading comes very close to paying for cost of interval metering technology
Price of metering technology falling rapidly
Sophistication of metering technology rising rapidly
Virtually all households have Internet access and can receive price signals on real-time basis
Regulator can coordinate a competitive procurement process for provision of interval metering infrastructure to regulated distribution companies
Purchase cheapest meters that record hourly consumption

53. Challenges that Make Market Design Problem in New Zealand Extremely Difficult

54. Vertical Integration
Four largest suppliers in New Zealand are vertically integrated into retailing
Firms are called “gentailers”
Vertical integration between electricity generation and retailing effectively eliminates beneficial incentive of fixed-price forward market obligations on supplier behavior
A fixed-price forward contract between retailer and supplier within in same firm has no impact of supplier’s offer behavior
Supplier agrees to sell QC at PC to retailing affiliate
Retailer agrees to buy QC at PC from generation affiliate
No net impact of behavior of vertically-integrated firm because sale and purchase nets to zero within firm
Gentailer still has same incentive to exercise unilateral market power

55. Vertical Integration
Suppliers have little incentive to develop liquid market for fixed-price forward contracts
They own physical assets needed to serve retail customers local to their generation units
Developing a liquid forward market for energy would help retailers that do not own generation units compete in their service territory
With vertical integration, fixed-price retail market obligations with final consumers limits incentive of supplier to exercise unilateral market power, but only for duration of contract
Suppliers recognize that higher wholesale now prices can provide rationale for raising retail prices in future
Vertical separation of generation from retailing creates level playing field for retail competition
Provides strong incentive for retailers and generation unit owners to enter into fixed-price forward contracts for energy

56. Hydro-Dominated System
Hydro-dominated system makes achieving competitive market outcomes during low water conditions is extremely difficult
Hydro suppliers attempt to conserve water by submitting steeper offer curves
Thermal suppliers perceive steeper residual demand curves and submit steeper offer curves
Output prices rise because of steeper offer curves and hydro suppliers find that they sell “too much water” and further steepen their offer curves
Thermal suppliers respond by submitting steeper offer curves and prices rise further
This dynamic has operated in all bid-based hydro-dominated markets around the world—New Zealand, California, Colombia, Spain

57. Hydro-Dominated System
If hydro suppliers have re-insured water shortfall risk with thermal suppliers, impact of this dynamic can be limited
Suppose thermal suppliers sign contingent contract with hydro suppliers to provide more energy at a fixed-price if water level falls below some pre-specified value
Thermal suppliers have no incentive to raise wholesale price in response to steeper offer curve of hydro suppliers because they must make up hydro energy shortfall at fixed price
Contingent contract would involve up-front payment by hydro suppliers to thermal suppliers for insurance against energy shortfall
Vertical separation between generation and retailing can increase attractiveness of reinsurance for hydro suppliers and electricity retailers

58. Transmission Congestion
When transmission congestion in New Zealand occurs there can be extremely large price differences across locations
Provides strong incentive for gentailers to consolidate load to nodes near where it owns generation units
Increases riskiness of entry by retailer that owns no generation
Buying out of short-term market to serve retail consumers can be extremely risky because of potential for congestion
Finding a long-term hedge for locational wholesale energy price is difficult because firm most able to provide it is incumbent gentailer
Market with long-term financial transmission rights and long-term energy contracts more likely to develop with less vertical integration

60. What is Next for New Zealand Wholesale Electricity Market?

61. What is Next for New Zealand?
Major lessons from re-structuring processes around the world
Decide which segments of industry will employ a regulatory process to set prices and apply best possible regulatory mechanism
Transmission and distribution
Decide which parts should use market mechanisms to set prices and apply best possible market mechanisms
Generation and retailing
Implement proactive market monitoring process to detect and correct defects in market rules
Measures of ability and incentive of suppliers to exercise unilateral market power
Measures of market performance relative to competitive benchmark

62. What is Next for New Zealand?
Improving regulatory process
Establish an explicit and publicly observable regulatory price-setting process for transmission and distribution services
Regulated firms submit publicly disclosed annual reports on revenues and costs and assets and liabilities using international regulatory accounting standards
Regulatory process for setting output price is public process were interested parties can participate and provide testimony to regulator
Regulator can only rely on evidence presented in public process to arrive at regulated price
Failure to do so can result in decision being overturned
on legal review

63. What is Next for New Zealand?
Regulatory process should
Establish a rate base for regulated entities (RB)
Sum of past prudently incurred investment costs less accumulated depreciation computed from publicly disclosed financial information
Set risk-adjusted rate of return on capital (r)
Determine prudency of investment decisions (only prudent investments are allowed cost recovery in output price)
Set test year output level (Q)
Estimate variable cost of test year output (VC(Q))
Set regulated price as p = (r*RB + VC(Q))/Q
Set single price for all customers of a given class (residential, commercial, industrial) for transmission and distribution services for given distribution network area

64. What is Next for New Zealand?
On retailing and generation market competitiveness
Single distribution and single transmission price for a given customer class for a given distribution network increases transparency of retail prices to final consumer
Only reason for differences in retail price offers to customers by retailers is wholesale energy costs because transmission and distribution charges to serve customer are the same for all retailers
Potential to increase competitiveness of retail market outcomes
Transparent transmission and distribution pricing will make it easier to measure competitiveness of retail market outcomes
Implicit wholesale price = P(retail) – P(transmission) – P(Distribution)
Data collection for retailing segment of industry to compute average retail price which can then be used to assess competitiveness of retailing segment

65. What is Next for New Zealand?
Symmetric treatment of load and generation for customers with interval meters
Retailer must pay actual cost of serving customer with interval meter each half-hour of the day
Establishing interval metering as a regulated distribution service in New Zealand seems cost effective
Encourage development of dynamic pricing of retail consumers to increase competitiveness generation and retailing
Dynamic pricing—Retail prices that vary with real-time system conditions
Time-of-Use pricing simply sets higher price in certain hours of day regardless of real-time system conditions
Ample evidence in US, Japan, Europe of significant demand reductions in response to dynamic pricing
Wolak (2010) An Experimental Comparison of Critical Peak and Hourly Pricing: The PowerCentsDC Program
Ito (2013) Using Dynamic Electricity Pricing to Address Energy Crises: Evidence from Randomized Field Experiments (with Takanori Ida and Makoto Tanaka)

66. What is Next for New Zealand?
Multi-settlement market makes active demand-side participation much more straightforward that current single settlement market
Large consumers and retailers can purchase energy in day-ahead market and sell it back in real-time
Avoids problem of selling something that consumer or large retailer does not own
Real-time market price penalizes demanders that consume more than day-ahead purchase
In single settlement market must come up with ad hoc rules to penalize over-consumption relative to “purchased” amount

67. What is Next for New Zealand?
Address equity issues associated with higher residential electricity prices
All US states and most industrialized countries provide subsidized electricity to low income consumers
California has CARE program which provides subsidized electricity to low income consumers
Low income consumers can pay a large share of monthly budget on electricity
Particularly acute for low income consumers on South Island
An important role of regulatory process in the US is to protect those consumers that find it hard to protect themselves
Higher income consumers should be able to take actions to reduce bill
Switch suppliers, install technology to increase flexibility of their half-hourly demand

68. What is Next for New Zealand?
Transmission expansions to reduce frequency and magnitude of congestion
Limits geographic basis risk to new entrants to retail markets distant from their generation units or forward contract delivery points
Transmission expansions increase number of half-hours per year each generation owner faces competition from all generation unit owners in New Zealand
Makes distribution of residual demand curve a generation unit owner faces flatter, reducing its ability to exercise unilateral market power, which Increases the competitiveness of short-term market outcomes
Transmission planning process that accounts for these consumer benefits will improve competitiveness of wholesale market outcomes

69. Vertical (Dis)-Integration?
Separating generation from retailing would certainly help, but there are other less extreme regulatory interventions
Proactive market monitoring process for wholesale and retailing segments of industry that measures performance of these two markets can assist in design of appropriate interventions
Andrew Philpott (University of Auckland) excellent work on computing competitive counterfactual wholesale market price
Develop methodology to derive counterfactual competitive retail price
Regulator adopts “official price benchmarks” and collects data necessary to compute them
Improves regulatory credibility (experience from California)
Comparing benchmarks to actual market outcomes can diagnose possible market design flaws and design interventions that improve market performance

70. Process of Continuous Improvement
All wholesale electricity markets must adapt to changing technology, policy goals, and market participant behavior
Proactive market monitoring process is key to adapting to changing circumstances
All regulators must engage in critical self-assessment of market performance relative to competitive benchmark to ensure consumers benefit from electricity re-structuring
Recall that process of finding optimal market design in other industries is not available for electricity
Market monitoring process can point the way to “optimal market design,” but this is process of continual learning and implementation of knowledge

71. Conclusions
New Zealand faces many difficult challenges in achieving a restructured market that benefits consumers
Best practice regulatory process for monopoly segments and market monitoring and market rule making process can achieve this goal
Recognize and embrace fact that managing unilateral market power is major challenge of wholesale market regime
Regulate monopoly segments to enhance competitiveness of wholesale and retail segments
Push on margin of making incurred cost equal minimum cost
Transparent distribution and transmission pricing
Active participation of final consumers in wholesale market
Transmission planning process that accounts for competitiveness benefits of expansions
Design market rules to limit adverse impact of vertical integration and hydro-dominate electricity supply
Data collection and market performance measurement and monitoring crucial to this process

72. Related papers and presentations at

73. Bid-Based versus Cost-Based Markets in Hydro-Dominated Electricity Supply Industries

74. Cost-Based Markets in LACs
Several hydro-dominated Latin American Countries (LACs) have a long history with electricity supply industry re-structuring using a cost-based short-term market
Chile has had a wholesale market since mid-1980s
Almost 300% increase in capacity since 1990, all privately financed
Argentina has had a wholesale market since early 1990s
Brazil, Peru, Panama, and Guatemala also run cost-based markets
Under a cost-based market, suppliers submit technical characteristics of their generation units to market operator
Heat rates, variable operating and maintenance costs
Market operator computes variable cost of generation units using input fuel prices and from this information computes opportunity cost of water, usually by solving a stochastic dynamic program
Market operator dispatches units and sets market-clearing prices using these variable cost estimates
Galetovic, Munoz, and Wolak (2013) summarizes dispatch and pricing process for Chilean market
Wolak (2008) discusses the case of Brazil

75. Cost-Based Markets in LACs
Experience of Chile is generally thought to be a success
LACs focus on what is needed to attract new investment—active forward market
Based on US experience, it is difficult to argue that bid-based short-term markets have benefited consumers
Many opportunities for suppliers to exercise unilateral market power
LAC cost-based market focuses on development of forward market for energy
Short-term market used to clear imbalances relative to forward market positions
No regulatory intervention in market for fixed-price forward contracts between generation unit owners and retailers
However, because of cost-based short-term market, retailers have limited incentive to sign fixed-price forward contracts

76. Downside of Cost-Based Markets
Mandated forward contracting levels for retailers enforced by regulator
Specify minimum hedging requirements at various time horizons to delivery, for example
95% coverage 1-year in advance of delivery
90% coverage 2-years in advance of delivery
85% coverage 3-years in advance of delivery
Contracting levels enforced by penalties set by retailers
Specify cost-of-shortage in stochastic dynamic program used to compute opportunity cost of water
Political pressure to set low cost of shortage, which sets low wholesale prices in a cost-based market
Low cost of shortage makes shortage periods increasingly likely because it sets a low opportunity cost of water and more water being used
Brazil, Chile and other cost-based markets have faced several shortage periods when firm load had to be curtailed

77. Old Problems in New Regime
Technology of production dictates single transmission network and distribution network for a single geographic area
Regardless of market structure—vertical integration or wholesale market
Regulation of prices transmission and distribution owners charge, operating behavior, and expansion network decisions needed under either regime
In former regime it was done implicitly through the retail price
In new regime it must be done explicitly
Standard regulatory challenges remain in new regime
Asymmetric information between firm and regulator about minimum cost mode of supply
Determine prudency of investment and operating decisions
Provide incentives for least cost production

78. New Problems in New Regime
New regime requires regulatory process to design wholesale market and monitor its performance
Firms in all industry segments will attempt maximize profits subject to mechanism used for regulated segments of industry
Regulator must recognize and account for fact that all market participants behave strategically
Market design and market monitoring process can have an enormous impact on market outcomes
Rather than set prices that are “just and reasonable”, regulator must now implement market rules that result in market prices that are “just and reasonable”
Massively more complex task (economists can help)

79. Adam Smith on Market Design
“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages.”
The Wealth of Nations, Book I Chapter II