1. Market Power and the Monitoring of Wholesale Electric Power Markets Jim Reitzes Energy Bar Association – Mid-Year Meeting December 3, 2009

2. 1 I.Why Are We Concerned about Market Power in Wholesale Electric Power Markets? II.“Market Power” vs. “Abuse of Market Power” III.Market Monitoring in U.S. RTO Markets IV.Differences in Market Monitoring Philosophies V.Closing Thoughts Agenda

3. 2 Why Are We Concerned about Market Power in Wholesale Electric Power Markets? Restructured electricity markets are susceptible to the exercise of market power by suppliers for several reasons: Short-term demand for electricity is very price-insensitive. Network limitations of transmission systems impede the movement of electric power across geographic areas when transmission lines are congested. ► Consequently, the true geographic market in which power flows freely may be relatively small and concentrated. Entry is costly and takes time.

4. 3 Why Are We Concerned about Market Power in Wholesale Electric Power Markets? (cont.) Electricity “supply curves” often have a series of steps. ► Each step represents a movement to a more costly fuel source or technology (e.g., from nuclear to coal to natural gas to fuel oil) The supply curve for electric power often increases substantially when output is close to full capacity. As a result, withholding small amounts of electricity output may produce a large impact on energy prices, since the market-clearing price moves to a higher step in the supply curve. In addition, the repeated interaction among sellers and buyers in day- ahead or day-of electricity markets may enhance firms’ abilities to tacitly coordinate their behavior.

5. 4 Single Supplier Economic Withholding

6. 5 If supplier XYZ bids in its units at a constant markup, the market supply curve is pulled in and up…resulting in higher market prices. $110,300$ 130,050$ 58,000 Supplier XYZ Profits ($/hr) $ 72,050 2,700 60 Supplier XYZ with 105% (optimal) Markup $ 52,300NA Additional Profits from Markup ($/hr) 2,0003,150 Supplier XYZ Dispatch (MWh) 7332 Market Price ($/MWh) Supplier XYZ with 200% Markup No Markup Supplier XYZ Profits ($/hr) Supplier XYZ with 105% (optimal) Markup NA Additional Profits from Markup ($/hr) Supplier XYZ Dispatch (MWh) Price ($/MWh) Supplier XYZ with 200% Markup No Markup

7. 6 Market Power and Market Monitoring Due to concerns that the withholding of electric power could lead to substantial increases in price, which could be quite costly to electricity consumers (even if these price increases lasted only a few hours or days), RTO-based electricity markets are subject to active market monitoring and, in some cases, ex ante mitigation. ► This concern has been heightened by the behavior of the UK energy markets during the 1990s, the California energy crisis, prices spikes in the Midwest in the summer of 1998 and 1999, and recent price spikes in ERCOT. Thus, despite the fact that they are composed of many suppliers, and are not a natural monopoly, RTO-based electric generation markets are effectively regulated when certain conditions arise.

8. 7 I.Why Are We Concerned about Market Power in Wholesale Electric Power Markets? II.“Market Power” vs. “Abuse of Market Power” III.Market Monitoring in U.S. RTO Markets IV.Differences in Market Monitoring Philosophies V.Closing Thoughts Agenda

9. 8 Market monitoring and mitigation in electric power markets are geared toward eliminating the “abuse” of market power. Since almost all markets have some degree of market power, the identification of market power “abuse” may require the market monitor to distinguish between a reasonable and an unreasonable degree of market power. ► This distinction is a regulatory creation, not particularly an economic one. ► Presumably, an unreasonable degree of market power leads to prices that are not just and reasonable. Market Power vs. Abuse of Market Power

10. 9 What Is a Substantial Deviation from a Competitive Outcome? Market monitors therefore must determine what is a substantial deviation from a fully competitive outcome that warrants mitigation. ► Such thresholds differ substantially across RTOs and different product markets. ■ RTOs (other than ERCOT) define abuse of market power indirectly by specifying the types of behavior that they mitigate (e.g., physical or economic withholding of output). ► Impact thresholds are FERC’s clearest indication of substantial deviations to date.

11. 10 I.Why Are We Concerned about Market Power in Wholesale Electric Power Markets? II.“Market Power” vs. “Abuse of Market Power” III.Market Monitoring in U.S. RTO Markets IV.Differences in Market Monitoring Philosophies V.Closing Thoughts Agenda

12. 11 Mitigating Market Power in RTOs – Structural vs. Conduct-and-Impact Mitigation Despite similar market designs and structures across RTOs, two substantially different ex ante mitigation approaches arise: (1) structural tests (PJM, new CAISO, and ERCOT) ♦ PJM and CAISO use “three joint pivotal supplier” (“3JPS”) screens to trigger mitigation (although implementation details differ significantly). (2) conduct-and-impact tests (NYISO, ISO-NE, and MISO)

13. 12 Structural Tests Structural tests impose automatic mitigation based on market structure conditions that are consistent with the ability (if not the incentive) to exercise market power. ► Since they focus on ability rather than the incentive to exercise market power, strict structural tests may be prone to over-mitigation (i.e., imposing mitigation when a market participant is not engaging in market power abuse).

14. 13 Conduct-and-Impact Tests Conduct-and-impact tests impose mitigation only if a firm’s actual bidding behavior is inconsistent with a competitive benchmark and has a material impact on market-clearing prices.

15. 14 3JPS Screen PJM – If 3 suppliers can jointly congest (and by implication, de-congest) a transmission constraint, those suppliers bids are then mitigated to cost-plus- 10%. CAISO - Intra-zonal constraints are deemed to be non-competitive if they require output from three or fewer suppliers to resolve, based on an annual or seasonal system-wide run of CAISO’s power flow model. In day-ahead (DA) and real-time (RT) markets, the incremental output required to relieve the non-competitive constraints will be mitigated to “cost plus 10%.”

16. 15 Implementation Differences between PJM and CAISO PJM uses its screen as frequently as every five minutes in the real-time market, as constraints arise. ► CAISO uses its screen annually and eventually seasonally to identify noncompetitive constraints. PJM applies its screen one constraint at a time, supplier by supplier. ► CAISO tests for simultaneous feasibility of an entire system when identifying non-competitive constraints.

17. 16 Implementing MISO's Conduct-and-Impact Test in Broadly Constrained Areas (BCAs) For the conduct part of the test, the preferred price reference level is based on the average of bids accepted in “competitive periods” over the previous 90 days, adjusted for changes in fuel prices. ► For suppliers having a significant impact on binding transmission constraints (in BCAs), the conduct test is failed when a supplier’s bid into the energy market exceeds the minimum of 300% of the reference level, or the reference level + $100/MWh. The impact part of the test is failed, if all of the bids failing the conduct test result in any LMP increasing by a minimum of 200%, or $100/MWh. All bids failing the conduct and impact tests are mitigated to their reference level. This process is fully automated in RT.

18. 17 I.Why Are We Concerned about Market Power in Wholesale Electric Power Markets? II.“Market Power” vs. “Abuse of Market Power” III.Market Monitoring in U.S. RTO Markets IV.Differences in Market Monitoring Philosophies V.Closing Thoughts Agenda

19. 18 Structural vs. Conduct-and-Impact Tests Pronounced differences apparently exist between those advocating structural tests and those advocating conduct- and-impact tests with respect to the perceived costs of “false positives.” Advocates of structural tend tend to view “false positives”– (that is, the imposition of automatic bid mitigation in the absence of actual market power) – as being of limited harm. ► Particularly if mitigation is based on unit marginal costs.

20. 19 Structural vs. Conduct-and-Impact Tests (cont.) Advocates of conduct-and-impact tests seem to be more wary about impact of “excessive” mitigation on investment incentives and market efficiency: ► Excessive mitigation may reduce market prices, and impede investment (raising resource adequacy issues). ► Potentially costly changes in plant operations result from automatic bid mitigation. A combination of the two approaches may be the best solution. ► Use structural screen to identify situations that are susceptible to the exercise of market power, and then a conduct-and-impact test to see whether market power is being exercised.

21. 20 I.Why Are We Concerned about Market Power in Wholesale Electric Power Markets? II.“Market Power” vs. “Abuse of Market Power” III.Market Monitoring in U.S. RTO Markets IV.Differences in Market Monitoring Philosophies V.Closing Thoughts Agenda

22. 21 Closing Thoughts: Where Are We? Current paradigm of wholesale electricity markets is that of a regulated oligopoly, which is unusual. ► Despite the mitigation of generation bids down toward marginal cost in transmission-constrained areas (under certain structural screening tests), incentives still remain under this form of regulation for generators to lower their costs further to earn infra-marginal rents. ► So, while the current nature of market power mitigation constitutes a strange form of regulation, more investigation is needed as to its costs and benefits.

23. 22 Closing Thoughts: Dangers of “False Positives” Aggressive ex ante mitigation that results from the application of stringent structural tests may produce “false positives” when no significant market power exists. ► This is potentially problematic unless there is limited harm in overmitigating.

24. 23 Closing Thoughts: Does The Nature of Energy Market Mitigation Affect Capacity Market Design? By constraining energy prices to levels associated with incremental production costs, aggressive ex ante mitigation in the energy markets places a considerable burden on the capacity markets to produce remuneration to generators and spur resource adequacy.

25. 24 Closing Thoughts: Market Monitoring Approach and Market Design Arguably, conduct-and-impact-based mitigation is applied in a more relaxed fashion than mitigation based on structural tests. In this situation, one might argue that investment incentives facing generators are less directly driven by the design and behavior of capacity markets in these jurisdictions. ► There is more “margin for error” in the regulatory design pertaining to the capacity market.

26. 25 Closing Thoughts: The Key Concern The potential downside to overly stringent mitigation of market power in the near term is the lack of investment that makes market power abuse a longer-term problem. The potential downside to insufficient mitigation is substantial consumer harm in the near term. What is the right balance?