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The Future of Electric Competition: Concentrated Power

Fortnightly Magazine - February 2005

a consequence, many new entrants did exactly that (, they built new gas capacity). Initially, the incumbent generators were willing to yield market share to maintain prices. However, this process went on so long that the incumbents realized they would no longer be able to control prices, and in 2000 they decided to increase their own output. Prices collapsed as a consequence.

The crucial point to observe is that wholesale power prices now appear to be set at a small premium, £5/MWhe, above the higher of the coal or gas marginal costs. This is exactly the behavior to be expected of a highly competitive commodity market. However, the problem facing the authorities, given these prices, is whether there is sufficient incentive for the private sector to maintain sufficient generating capacity. Or, more importantly, whether there is sufficient incentive for new entrants to build new capacity. Although this has been a rather "academic" question over the past decade, the surplus capacity is likely to run out in the next two to three years. Figure 2 shows the demand and plant forecast by the National Grid for 2004, including one demand forecast and three generation capacity forecasts, together with estimates of the associated "plant margin." The first capacity forecast (SYS) shows the forecast based on existing plant and all projects with "connection agreements" with National Grid; the second (consented) shows operational plant and projects that hold all the necessary permits; the last shows just plant in operation and projects under construction.

Given the current depressed generation margin, it is unlikely that developers will be keen to commit to construction in the absence of a rally in potential profitability. Thus the "under construction" curve gives the best estimate of the balance of supply and demand and suggests that, by 2007-2008, the plant margin will have fallen to less than 15 percent. It is not yet clear whether such a narrow margin will give rise to a substantial increase in prices. Such a situation has not previously been experienced in England and Wales, and it is not certain whether a price rise will give sufficient warning for developers to invest in new capacity.

Indeed, consideration of competitive power markets suggests that the price behavior could be expected to follow one of the two forms shown in Figure 3.

The green line shows the full cost of a "new entrant." An oligopoly would be expected to set prices at or just below this level. This would enable them to maintain profitability and market share because their cost of construction, and probably capital, would be lower than that of an independent new entrant.

The blue line shows the behaviour of a fragmented market, where prices stay just above marginal cost when there is surplus capacity but rise dramatically when demand exceeds supply. The factors determining the price in fragmented markets are:

  • The time between peaks (T2); probably related to the unit of new capacity and inversely related to the rate of demand growth;
  • The magnitude of the peak (h); and
  • The peak's duration (T3) related to the construction