Analysis of electricity industry liberalization in Great Britain: How did the bidding behavior of electricity producers change?
Introduction
Great Britain was the first among the OECD countries to liberalize its electricity supply industry. Liberalization included splitting up the previously vertically integrated utility into its production and infrastructure parts and creating a wholesale market to exchange electricity between producers and retail suppliers in England and Wales. Trading was organized as a uniform price auction, where electricity producers are asked to bid prices at which they are willing to produce electricity.
Research has shown, however, that producers have exercised market power by submitting price bids significantly exceeding marginal costs (for example, Crawford et al., 2007, Sweeting, 2007). An exercise of market power leads to higher uniform auction prices, i.e., the System Marginal Price (SMP), and, therefore, higher revenues for electricity producers. A higher SMP increases payments by retail suppliers, which are in the end reflected in higher prices paid by consumers. Another consequence of an exercise of market power is the possible loss in the efficient allocation of production facilities. In other words, due to possible differences in setting bid markups, there need no longer be any guarantee that, based on ordered price bids, the least-cost production facilities are indeed scheduled to produce electricity.
These market power issues are also discussed in Bergman et al. (1998) in the analysis of the first form of benefits that electricity market reforms could bring to consumers: lower prices resulting from lower price-cost margins and more cost-efficient electricity production. Other benefits that electricity market reforms could bring to consumers include a high degree of security of supply and an environmentally friendly electricity supply system, which in the long run would not critically depend on exhaustible natural resources.
As part of the liberalization process, in order to mitigate an exercise of market power by incumbent electricity producers, the regulatory authority, the Office of Electricity Regulation (Offer, later constituted as the Office of Gas and Electricity Markets, or Ofgem), introduced several reforms. This paper analyzes how the regulatory reforms affected the bidding behavior of electricity producers. In particular, we quantify and document new empirical evidence about how the incentive and disincentive to exercise market power changed over the 1995–2000 period.
The measures designed to mitigate an exercise of market power and promote competition during the liberalization process were more extensive in Great Britain when compared to Germany, France, Italy, or Sweden (Bergman et al., 1998). Joskow characterizes the privatization, restructuring, market design, and regulatory reforms pursued in England and Wales as the international gold standard for energy market liberalization (Joskow, 2008, Joskow, 2009). In this respect, the new findings documented in this research could be of interest to countries that have structured or are about to structure their electricity markets similar to the original model adopted in England and Wales.
Section snippets
Regulation in the electricity supply industry
The institutional changes and regulatory reforms that took place in the production level of the electricity supply industry (ESI) in Great Britain during the 1990–2001 period are summarized in Fig. 1 and described in detail in the following paragraphs.
The UK regulatory authority noted the growing discrepancy between rising wholesale electricity prices and falling fuel costs, and specifically the sharp increase in electricity prices in April 1993.1
Related literature
Seminal research in modeling electricity auctions is presented in Von der Fehr and Harbord (1993). The authors assume that N electricity producers serve the British electricity market operated as a uniform price auction. They also assume that marginal costs are common knowledge and differ only across electricity producers. The last assumption implies that all production units of a certain electricity producer have the same marginal costs, which can be partly supported by the fact that during
Methodology
For the analysis of the bidding behavior of electricity producers, we assume no uncertainty in the forecast demand for electricity and that the marginal costs of electricity production can be approximated. The first assumption is based on the fact that the methodology the market operator (i.e., the National Grid Company) applied to forecast electricity demand, for each trading period of the following trading day, was common knowledge (Wolak, 2000, Wolak and Patrick, 2001) and independent of
Data
The two data sets used cover the period from January 1, 1995 to September 30, 2000. The first data set contains half-hourly market data on the forecast demand for electricity and System Marginal Price (SMP). Summary statistics for the market data are presented in Table 1.
The maximal value of the SMP corresponds to the highest spike in 1995, which was brought about by a mistaken mix of technical parameters that the Generator Ordering and Loading (GOAL) algorithm had to accept.7
Results and discussion
Section 4.2 introduced the specification of the regression model to evaluate the impact of the regulatory reforms on producers' bidding behavior. The choice of a log-linear functional form of the regression model is based on the first-order condition from the expected profit maximization problem in the duopoly case discussed in Section 4.1. Log-linear regression models are often used in empirical research, in part because the estimated slope coefficients in this specification can be directly
Conclusions
This paper examines the impact of regulatory reforms introduced during the liberalization process of the electricity supply industry in Great Britain on the bidding behavior of electricity producers. For this purpose, a duopoly model is considered in order to identify the incentive and disincentive to exercise market power. As the model suggests, a producer has an incentive to submit a higher price bid in excess of marginal cost for a production unit when that producer has a larger capacity
Acknowledgments
I would like to express my gratitude to Lubomír Lízal, Jan Kmenta, Janice Beecher, and referees for their detailed comments and suggestions. I am also very grateful to Richard Green, Andrew Sweeting, the Department for Business, Innovation and Skills (formerly, the Department of Trade and Industry), the Office for National Statistics, National Grid plc, and Ofgem for providing access to data and publication materials.
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