1 Competition Policy and Regulation in Hydro-Based Electricity Markets Luiz Rangel Energy Centre, University of Auckland September 2007

2 Introduction Traditionally, energy economics literature focuses on static models. Adequate for representing thermal systems, but hydro is dynamic. Different technologies correspond to different incentives and methods of exploiting market power.

3 Introduction Key market power issue: strategic allocation of a given amount of output across periods Rather than a straightforward reduction of total output (as in thermal systems).

4 Market power: sources and facilitating factors Factors that constrain firm’s ability to unilaterally affect the market price: Demand substitutability Supply substitutability Potential competition

5 Market power: sources and facilitating factors Factors limiting demand substitutability Use of smart/real-time meters still limited Consumers therefore do not react to changes in real-time prices Less of a problem in hydro-based systems, since strongest price fluctuations are from season-to-season or year-to-year. Long-run elasticity higher than short-run elasticity

6 Market power: sources and facilitating factors Factors limiting supply substitutability Generation capacity constraints Hydro plants are less often capacity- constrained than thermal plants Competition policy analyses should give attention to type of technology of competition

7 Market power: sources and facilitating factors Factors limiting supply substitutability Transmission capacity constraints May be more of a problem in hydro systems: plants have to be built where the resource is, requiring transmission

8 Market power: sources and facilitating factors Factors limiting supply substitutability Technological constraints Unit-commitment problem: ramping rates, start-up and shut-down costs Hydro plants are more flexible and can respond more quickly to price changes Once again, competition policy analyses should take into account the type of technology of competitors

9 Market power: sources and facilitating factors Factors limiting potential competition High fixed costs and long lag periods Forecasting about the timing of recovery of capital costs can be more complex Best hydro sites already occupied Environmental regulations/resource consent

10 Strategic allocation of water First papers from O.R. literature: Scott and Read (1996), Kelman, Barroso and Pereira (2001) Crampes and Moreaux (2001) and Bushnell (2003) Hydroelectric resources smooth the price profile in a perfectly competitive environment; in contrast, strategic hydro generators tend to sharpen the peaks.

11 Strategic allocation of water Bushnell (2003): even though peak loads are higher in June than in September, price distortions are actually less dramatic in June, when more water is available. Mathiesen, Skaar and Sørgard (2003): the reallocation of hydro output is actually related to relative demand elasticities, rather than demand levels.

12 Strategic allocation of water Garcia, Reitzes and Stacchetti (2001): Price- caps affect prices even when the cap is not binding Price-caps therefore play an even stronger disciplining role in hydro-based markets compared to thermal-based markets Likelihood of collusion increases with reservoir levels and the probability of water inflow: punishment becomes more credible

13 Interaction with transmission constraints Borenstein, Bushnell and Stoft (2000) Static (one-period) model How are things different in hydro systems?

14 Interaction with transmission constraints Johnsen (2001) Firms have excessive incentives to export energy early on, so that storage is below the socially optimal Increasing transmission capacity may actually be detrimental to competition!

15 Interaction with transmission constraints Skaar and Sørgard (2006) Cross-regional mergers/acquisitions in hydropower markets with transmission bottlenecks Mergers may increase social welfare, even if no efficiency gains Firm will internalize detrimental effects of congestion on the exporting area

16 Effects on system reliability Garcia, Reitzes and Stacchetti (2001) Conditions under which hydro replaces thermal If price caps are set too low, reliability is compromised: the value of holding onto water will be low, so hydro producers will undercut thermal producers

17 Effects on system reliability Garcia, Reitzes and Stacchetti (2001) What if different plants face different hydrological conditions? Firms with greater probability of replenishment may have either a higher or lower opportunity cost of selling power in the current period If higher opportunity cost, reliability may be compromised!

18 Some conclusions and policy implications A merger between two generators who operate well below capacity most of the time should be viewed with greater care than a merger between two generators that operate at or near capacity A merger between two generators with flexible production technologies (reservoir hydro) should raise more concern than a merger between two generators with inflexible technologies (thermal)

19 Some conclusions and policy implications Mergers between generators located inside the same load pocket deserve more care than mergers between generators located in different geographic areas A merger between generators that are close to each other in the merit order is more problematic than a merger between generators with very different marginal costs