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Price Spike Reality: Debunking the Myth of Failed Markets

The data is in. Market power fails as an explanatory variable for episodes of high prices.
Fortnightly Magazine - November 1 2000

 

The data is in. Market power fails as an explanatory variable for episodes of high prices.

The past summer represented a key turning point in our understanding of deregulated wholesale power markets. Until then, it was possible to find major North American markets that lacked any experience with severe price spikes. Now that immunity is denied. Price spikes in California and other Western markets mean that the last regions bucking the trend have fallen in line.

Moreover, this change tells us something about the nature of price spikes. In fact, the data indicate that "market power" fails as an explanatory variable for the price spike episodes observed so far.

Today, just as we have completed our fifth summer of trading electricity at deregulated wholesale prices, calls for re-regulation are louder than ever. Proponents of re-regulation argue that there is too much market power, prices are too high, there are too many price spikes, and the market cannot work. But after five years of collecting data, it has become apparent that market power does not cause price spikes. Another common view, often espoused by bureaucrats who would defend deregulation, argues that price spikes are rare "abnormalities." That claim, too, is been proved wrong by new price data.

One way to dramatize the widespread emergence of price spikes, and to track their cause, is to study the 12 months of prices, from July 1999 to July 2000, for all reporting markets. Price spikes occur when prices reach hundreds and thousands of dollars per megawatt-hour over the typical average of about $30 per megawatt-hour. Every market had price spikes above $70 per megawatt-hour (a measure of fuel and other short-run variable costs), with that energy bringing substantial revenues . Average profits in the United States during these spikes alone were enough to cover the investment cost of a "peaking" power plant in three years, even though the plant could operate for 30 years or longer. Another illustration is seen from looking at average prices for summer on-peak supply across the country during the last five summers . Every region had spikes at times—some in 1998, some in 1999, and some in 2000.

The truth, based on gathered data, is the best argument, and it presents a compelling case for continued deregulation. Prices often will spike at the summer peak, signaling both the need for more power plant construction and for reforms in the power industry. Now, just when the calls for re-regulation are loudest, a boom in power plant construction is proving the markets are working pretty well. These calls should not prevail, because the facts do not support their premises; rather we should finish the deregulation.

The Myth: Its Origins and Rationale

A common explanation for these spikes was that they reflected market power. This claim started with the first spikes in 1998 and continues unabated. From Washington, D.C., to California, experts claim to believe market power is the culprit. This matter has a technical dimension—that is, how should market power be factored in by analysts forecasting prices. More importantly, it has a

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