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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

policy dimension—should the experiment in deregulation be abandoned or greatly curtailed and the industry re-regulated.

If the goal is to determine whether market power is the cause of spike episodes, the data to do so is in. The numbers prove that market power fails to help explain the existence of spikes.

To see why, consider the following. If market power explains spikes in 1998 and 1999 in the Midwest and Southeast, what happened in 2000? Has market power decreased? If market power explains price spikes in California, why were they not present in 1996 through 1999? If anything, the market was more concentrated in 1996 before California conducted the largest forced divestiture in U.S. history of utility-owned power plants.

In reality, of course, the key driver of major price spikes is supply and demand at the peak. Strong demand growth due, in part, to a strong economy, episodes of hot weather, years of no power plant construction, and the end of above-normal volumes of hydropower have everything to do with California's problems, political grandstanding notwithstanding. Similarly, mild summer weather in the East and some new construction had a much greater impact on the past summer's power prices than did market power.

Finally, if the competitiveness of the market is not clear, consider the response to these spikes. New plants are under construction with potential capacity equal to nearly 10 percent of the nation's peak summer demand. Deregulation's premise of unlimited market entry is proving true.

Of course, the reason the market power myth persists goes beyond politics. It stems from the fact that price spikes reach levels above the short-run variable costs of even the most expensive unit—i.e., above fuel costs. No plant produces power for $1,000 per megawatt-hour once it is online.

Clearly, then, it is technically correct to say that markets are not perfectly competitive. The fuller truth, however, is at the heart of why price spikes reach thousands but not tens of thousands of dollars. Customers and their agents highly value power, but ultimately there is elasticity in the demand curve. At a certain price, customers or their agents do without.

At first glance, this distinction may seem like cold comfort and a weak reed. However, another view is that supply comes from either power plants or customers. In fact, incremental megawatts ("negative" megawatts) at the super peak come from the market paying for interruptible supplies. Indeed, the cost of interruption truly is about $1,000 to $10,000 per megawatt-hour nationwide. Thus, the price-takers setting the competitive price are interruptible customers or their agents (e.g., integrated utilities). The best view, then, is that the price is high but still competitive.

That is not to say that the market is as efficient as it could be. Customers and their agents can and eventually will improve their relationships. Remote control of loads via price-sensitive agents will translate into greater efficiency. That will lower the competitive price spikes.

Also fueling the market power argument is imperfections in the regulatory process. Indeed, the transition from regulation to deregulation has not been perfectly efficient, and