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The Future of Electric Competition: Concentrated Power

THE FUTURE OF ELECTRIC COMPETITION
Fortnightly Magazine - February 2005

perhaps, electricity is, after all, rather special. It suggests a power market can exist in only one of two states; oligopolistic or fragmented.

Contracts

The above analysis suggests that in a highly competitive fragmented power market, a developer would wait until spot prices are extremely high before committing investment in new generation capacity. Put simply, the risks of "missing the peak" are too great if the station relied on spot prices for revenues. But what about the possibility of obtaining a guaranteed price for power at a level that would cover both variable and fixed costs, including a return on capital? A forward market in electricity contracts of many years' duration has yet to emerge in England and Wales and is unlikely to do so, especially if there is competition at the domestic level. Put simply, a supplier would be foolhardy to enter into long-term contracts for power at prices in excess of marginal cost, since it would be undercut by competitors who continue to purchase on short-term contracts. Indeed, this is one of the reasons for TXU Europe's demise. While such forward markets develop for some other commodities, such as aluminum and steel, the products made from these minerals are sold on the basis of brand and intellectual property. The commodity cost is only a small fraction of the final product price. Purchasers of the commodity may feel more confident about buying for the long term.

The wholesale electricity price, on the other hand, represents around 40 percent of the final price to domestic customers. A better analogy is the oil sector, as the market for the final product is competitive and the product is a large proportion of the final price. Despite the maturity of the oil market, there is little liquidity in forward contracts of more than 6 months' duration. Thus it would be unwise to depend on the emergence of a medium- to long-term forward market in power contracts to protect customers from spikes in the wholesale power price.

On the other hand, if the domestic supply market were not competitive, suppliers may be sufficiently confident of their ability to pass on costs to customers that they might offer long-term contracts to generators at prices well in excess of marginal cost. This would allow generators to recover capital charges over many years, and not force them to recoup these costs over the one- or two-year period available to them in the fragmented market as prices spike. However, there then might be a requirement to ensure that these vertically integrated monopolies did not exploit their position by enjoying excessive margins in the supply business.

Alternatively, if there were fewer generators, they could hold prices above marginal cost and so enable them to carry surplus capacity to meet demand growth and amortize their investments over a longer period. Of course, under the circumstances of such "managed competition," it would be essential to ensure that access to the networks is open to all. This would ensure that the incumbent generators respond to reductions in new entry costs caused by movements in