To what extent should regulation yield to market forces in setting wholesale electric prices? The Federal Energy Regulatory Commission (FERC) posed this question when it sought comments on whether open transmission access would eliminate the need for anything like traditional rate regulation. But when the comments came back, the Department of Justice and others answered, "not necessarily."
Surely that is the correct answer. Transmission constraints and other factors can combine to produce pockets of substantial market power. The question is how to identify these pockets when they arise.
Market power on the part of sellers is the ability profitably to maintain prices above competitive levels by restricting output below competitive levels. This definition applies both to a single seller and to the collective market power exercised by a group of sellers.1 In this definition, the term "competitive price" means the equilibrium price in a competitive market (em i.e, the marginal cost of the most costly unit necessary to satisfy industry demand.
Which costs are marginal depends on the timeframe of a transaction. For a short-term sale of energy, marginal cost would be principally fuel costs, which would vary according to the type of generating unit (em from gas turbine and diesels units at the high end, to nuclear and hydro units at the low end. For a long-term sale of capacity, all costs would be marginal.
Some Basic Tenets
No firm or group of firms can possess substantial market power if industry demand for their product is highly elastic due to the availability of good substitutes.