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Is Competition Lacking in Electric Generation? (And Why It Should Not Matter)

Fortnightly Magazine - January 1 1997

The Effective Price Ceiling

Market power has limits, even when let loose by deregulation.

In the case of electric generation, even with deregulation and a head-start for incumbent power producers, we can expect to find a ceiling on the price of wholesale power as it evolves in a competitive market, owing to the cost advantage afforded by newly built, gas-fired, simple-cycle combustion turbines and combined-cycle generating plants. We can refer to this limit as the "equilibrium price ceiling," the "monopoly price ceiling," the "contestable price," or even the "rebuild price."2

This price ceiling lies one to three years out (em the time it takes to bring new plants on line (em which limits even unfettered generation market power. The ceiling equals the cost to new entrants of meeting customer demand for wholesale electricity with a mix of new gas-fired powerplants.

Observers have long argued that the future market for generation can be competitive since independents can build new gas-fired powerplants based on jet engine technology with low costs for capital investment. This claim rests several factors:

• Obtaining permits for new gas-fired plants has proven feasible throughout the country

• Transmission access is increasingly assured by deregulation

• Little technological sophistication is required for gas-fired operations, relative to older plant designs

• Electric demand is growing, raising the likelihood of capital recovery, even in a competitive market.

In effect, the price ceiling marks the cost of a rebuilt system. But the exact ceiling price is something of a paradox, for, as we have found, the cost of rebuilding the generation system (em the key constraint to a monopolist (em is actually lower (by about 15 percent), than the expected competitive price at long-run market equilibrium. This paradox occurs partly because new gas-fired powerplants carry a lower cost than older plants, and partly

because of the effect of capacity value.3 Figure 1 reveals how this "contestable" (or "rebuild") price lies below the expected competitive price for generation.

Regional Examples

We have selected three anonymous regions to illustrate the relationship between the competitive and rebuild prices. In each case, the rebuild price reflects the average cost for essentially rebuilding the generation system using a mix of gas-fired plants: 1) simple-cycle combustion turbines used for peaking and reserve back-up, and 2) combined-cycles plants for "heavier" operations. (See Tables 1, 2, 3.)

Surprisingly, the average rebuild price for the three regions is slightly lower than the expected competitive price (em by about 5 percent, or $1.50 per megawatt-hour (MWh). This quantitative result also highlights several important factors in electric generation: First, electric demand growth has wrung out some of the industry's excess capacity over the last few years, which should raise the expected competitive price. Second, the improvement in rebuild technology (gas plants) produces lower short-run variable costs. Third, available gas supplies plus an adequate selection of construction sites for new gas-fired plants in most regions makes the rebuild technology a viable competitor against incumbent producers.

How reliable are these estimates?

As shown in the tables, our analysis includes estimates of the uncertainty in the form of standard deviations). In