[BETA] Fortnightly

THE FUTURE OF ELECTRIC COMPETITION

An analysis of competitive power markets finds that oligopolies are the end game for liberalized power markets.

The British wholesale power market is about to enter a new phase. Having enjoyed a long period of surplus capacity, the combination of the forced retirement of some nuclear plant and continued demand growth is likely to lead to a capacity shortage within the next three to four years, and it is by no means clear whether the market, as it currently operates, will be able to maintain secure supplies.

There is evidence, in other markets, that such disruptions can be avoided. However, the power industry is not famous for looking outside its immediate vicinity to provide guidance. In the late 1990s, the German industry ignored the "British experiment" when preparing for liberalization. As a consequence, the collapse in prices took that industry completely by surprise. Similarly, the British and U.S. industries, and their financiers, were surprised when power prices fell to marginal cost at the turn of the century, despite the German experience.

Looking to other commodity markets can help us predict the future behavior of competitive power markets. Where commodity markets are highly competitive, markets have been likely to give rise to volatile price cycles, with prices driven by marginal costs for long periods, punctuated by short periods of extreme prices. Observation of commodities also suggests that a market in long-term contracts is unlikely to develop in many competitive energy markets. As a consequence, domestic customers will be exposed to extreme price volatility, which is unlikely to be politically sustainable.

Is an oligopoly structure the appropriate end game for liberalized power markets?

The British Experience

The behavior of spot prices in the England and Wales wholesale power market is shown in Figure 1 (). The red line shows the spot power price; the green follows the marginal cost of generating power in a combined-cycle gas turbine (CCGT) based on spot gas purchases, and the black line shows the same for coal. The difference between the red and green lines is often referred to as the "spark spread." Similarly, that between the red and black lines is the "dark spread." The chart clearly demonstrates that the gross margin for generation effectively vanished between December 1999 and June 2000.

It is not necessary, for the purposes of this paper, to determine the cause of the collapse precisely. Certainly, the introduction of NETA in April 2001 increased the downward pressure on prices by bringing the demand response explicitly into the price-setting mechanism, a feature missing from the superseded "Pool" system. In addition, the control of generation was becoming increasingly dispersed. The cause of this fragmentation, and the effective demise of the generating sector, is shown in Figure 1. The chart shows two different periods of price behavior. When the industry was first liberalized, the fossil generating capacity was controlled by just two players, which were joined by a third in 1997. These generators set prices well in excess of that required to build and operate a new gas station. As