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Identifying Market Power in Electric Generation

Fortnightly Magazine - February 15 1996

should not receive special weight in assigning market shares. All low-cost capacity is relevant to the benefit side of the market power tradeoff, and most high-cost capacity is marginal at some times. Moreover, any weighting scheme would be arbitrary.

An alternative to weighting is to compute a second set of market shares for mid-marginal cost

capacity, e.g., fossil-fueled units with relatively high average load factors. These market shares would not be used in place of those computed for all capacity, but could provide additional perspective as to whether market power could be exercised.

Measuring Concentration

Having assigned market shares, it is highly useful to summarize those shares with an index of

market concentration. The most popular index today, the

Herfindahl-Hirschman Index (HHI), is computed by squaring each market share, then adding up the squared shares. For example, for three firms with shares of 20, 30, and 50 percent, respectively, the HHI would equal 3,800 (400 + 900 + 2,500). The HHI approaches zero when there are a large number of very small firms, and equals 10,000 when there is just one.

Five equal-sized firms yield an HHI of 2,000. An HHI of 2,000 or less would reflect a reasonably competitive electric power industry (see sidebar, "Market Concentration and Market Performance"). Market power sufficient to warrant price regulation would entail even greater concentration, given the social costs of regulation.

In the context of oil pipelines, the Department of Justice has suggested that markets should be presumed sufficiently competitive for market-based pricing if the HHI falls below 2,500.5 Paul Joskow recently proposed the same rule for electric power generation,6 and I would be inclined to accept this rule as well.7

The rule should state that an HHI below 2,500 establishes a rebuttable presumption that market-based pricing would produce just and reasonable rates. Importantly, however, this presumption would still allow an intervenor to prove substantial market power despite the HHI.8

Even if the market HHI is high, a small individual firm would probably find itself unable to exercise market power if larger firms were subject to price regulation. Thus, a presumption of no market power could arise from a demonstration that a firm's market share is no more than, say, 20 percent.

Mitigating Market Power, Securing

Market Rates

I strongly urge the FERC to establish some market share and/or market concentration screens that could be used to establish a presumption in favor of market-based pricing. [Absent such a presumption, utilities can, of course, make a case for market-based pricing. Where enormous excess capacity exists relative to demand, for example, the distribution of excess capacity among firms becomes unimportant, making the market share of a single firm inconsequential, despite a large HHI.]

Presumptions based on market share or market concentration screens would allow utilities that are so inclined to assure that they pass through the screens. And I would have no qualms about utilities agreeing among themselves to take such steps so that all can secure the blessings of market-based pricing. Such a concerted effort would not seem to create any significant antitrust exposure.

The most