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

Fortnightly Magazine - January 1 1997

This prediction assumes that the FERC will succeed in eliminating the exercise of market power that large companies might exercise via their control of transmission.

Moreover, this lack of premium potential, attributable largely to supply alternatives offered by simple-cycle, gas-fired combustion turbines and combined-cycle plants, exists despite alleged uncertainties in natural gas prices, and remains independent of regulatory action aimed at limiting or controlling market power in generation.

Thus, would-be competitors in generation markets should concentrate their focus on market power in transmission (em not generation (em and on barriers to entry, such as permitting obstacles or factors that might discourage long-term contracts. t

1This approach applies "the contestable market approach" to the power sector. See, Baumol, Parzar, and Willig, Contestable Markets and the Theory of Industry Structure, Harcourt, Brace, Jovanovich, New York, 1982.2In the literature, the contestable price is the average cost of producing electricity combined with the lack of fixed cost. In our paper, we use the term contestable price because a developer could enter the business with very little commitment of his own funds. He could sign up customers, power equipment and fuel suppliers and project finance with little of his own capital. Later in this paper, we relax this assumption (em i.e., he does need a small amount of his own capital (em but do not change our basic conclusion.3This paradox makes it appear that rebuilding the system generally and immediately makes sense. This is not the case. Under a competitive market, as the rebuilding proceeded, the capacity component of the competitive price would collapse and the builders would lose money. It is only under the circumstances in which the monopolist (or oligopolists) have raised prices that new entrants can offer consumers a contract for power and then rebuild. See note 5, infra.4Assumes independence of the competitive and monopoly price; this is an overestimate in some markets where independence is low.5Our argument, thus far, can be seen as a pure contestable price argument. Entrants can enter without risking their own capital since they can project finance based on contracts with ultimate customers and plant and fuel suppliers.6The maximum magnitude of this price drop can be approximately estimated, on the theory that this excess capacity would erode the value of the "pure" capacity component of the competitive price for bulk power. If that would occur, and if and the capacity price would fall to zero, the power price would fall about 25% from the expected value, dropping the long-run equilibrium competitive price below the contestable (rebuild) price by about 25 percent, or about $7/mWh.For examples of how to calculate the capacity component (as distinct from energy value) of a deregulated price for wholesale power, see, "Unbundling the Electric Capacity Price in a Deregulated Commodity Market," by Judah Rose and Charles Mann, PUBLIC UTILITIES FORTNIGHTLY, December 1995, p. 20.

APPENDIXA. The Monopoly Price CeilingSome analysts have used a shorthand approach of assuming that the costs of rebuilding the system are the average costs of a new gas-fired combined cycle unit. This approach is inappropriate, however. Despite their low cost, simple-cycle