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Not So Fast

Proving market performance requires detailed analysis.

Fortnightly Magazine - January 2010

product, assuming other factors are the same. But this is true also for a monopoly or oligopoly market structure. A monopolist also would be expected to lower prices for its final product when input prices decrease. Even if fuel costs and wholesale prices were perfectly correlated, it would say very little about the performance of the market.

Likewise, a decrease in demand also will lower the price of the final product—again whether the product is provided by a competitive firm or a mono- polist. Put the two factors together, fuel costs and demand, and it would be a big surprise if we didn’t see wholesale electricity prices falling; even a pure monopolist would behave that way.

Real Market Analysis

All RTOs that have been approved by the Federal Energy Regulatory Commission (FERC) have a market monitoring function. Most of these monitors use concentration measures such as the Herfindahl-Hirschman Index (HHI) and pivotal supplier indices. These measures are useful tools to characterize market structure. However, they are screening tools to decide whether further investigation is necessary. They don’t provide a definitive answer on the exercise of market power or of market performance any more than does correlating fuel costs and demand with market prices. Producing large volumes of concentration ratios and indices doesn’t compensate for the inability of these measures to determine the performance of a market being examined. Even worse, overreliance on such measures can lead to incorrect or misleading conclusions on market performance.

The PJM market monitor repeatedly has concluded that energy markets, capacity markets and ancillary services markets are competitive and that prices aren’t the result of the exercise of market power. 4 This claim isn’t supported by the market monitor’s analysis, or any other publicly-available analysis.

To be sure, PJM’s market monitor goes further than do most RTO market monitors. 5 In addition to the standard concentration measures, PJM’s market monitor also estimates the mark-up of price over marginal cost, as a percentage of price (similar to the Lerner index). However, the usefulness of this measure depends critically on the scope of the analysis—for example, the products and the geographic area that are selected—as well as the time period used, and how the marginal cost is estimated. Simply put, if the measure is too broad or aggregated, the results will be of little or no value. Also, the quality of the data obviously will affect the results, and the estimation of the marginal cost presents perhaps the biggest challenge for the market analyst.

There are two basic problems with this approach and relying on it to make pronouncements of market competitiveness. First, even if a supplier were exercising unilateral market power, this approach wouldn’t necessarily detect it since the focus is on determining whether the marginal unit is operating at or near its marginal cost. Ignoring problems of estimating the marginal cost and assuming an approximate value can be determined, a firm exercising market power that’s able to raise the price above a competitive level wouldn’t need to raise the offer price above that unit’s marginal cost to enjoy