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Price Spike Tsunami: How Market Power Soaked California

Last year saw no shift in fundamentals. Then why was the ISO so willing to be deceived?
Fortnightly Magazine - January 1 2001

to reflect transmission. It also purchases reserves under a number of schedules from the operators in the area. If underscheduling has been present, supply and demand will not match, and the ISO will use its reserves to bring the two into balance. If the reserves are insufficient, it will resort to "out of market" purchases-purchases from the market to avert an operating emergency.

The supply curves (i.e., the day-ahead offers to the PX) are not related to actual operating costs. Potential suppliers can file whatever prices and quantities they choose. In practice, the aggregated supply curves show a number of curious features. They have tended to shift upwards during high price periods-apparently reflecting the suppliers' assumption that their bids will be accepted in spite of a sharp increase in price.

Describing and working with this complex data is not easy. One method of analysis involves calculating the average weighted price from the supply curve offered for a given period-the price times the supplies offered at each price. This analysis indicates the "height" of the curve and allows us to measure how it has shifted over time.

During ISO emergencies, the supply curve shifts upward dramatically. Logically, that could only occur if the market participants could operate cooperatively. If they could not rely on competitors joining them in an increase in the supply curve, they would be better off to maintain their current supply curve and take advantage of the activities of the other players.

Figure 6 is worrisome to an economist, since it indicates that the supply curve was considerably higher throughout the summer than we would expect from the underlying production relationship (the expected power price based on natural gas.) It is even more worrisome because there are dramatic divergences from even the high historical relationship between the California PX's average supply curve price and the historical estimate of the relationship between gas (the red line) and the PX supply curve. There is no clear operating reason for the supply curve to surge upwards-natural gas prices did not double during these periods, nor are there other clear reasons. 9

A competitor with excess capacity could have swept the market by simply running its unit full out. As we will see below, many California units did not operate at full capacity during these periods. It is highly unusual for a market participant to forego maximizing its profit during these periods unless some other strategy is being exercised.

Plant operations also tend to support the hypothesis that generation in California is characterized by strong market power. Two sources provide detailed data on plant operations-the Acid Rain database from the Environmental Protection Agency and the Extra-High Voltage (EHV) database from the WSCC.

We know from the prices experienced this past summer that May 22 was a major watershed. Consider two simple supply curves from actual generation data as supplied by the ISO. On the vertical axis are the prices at the California Oregon border actually experienced in the real market. On the horizontal axis is the actual production from the plants provided by the