An experimental analysis of the effects of automated mitigation procedures on investment and prices in wholesale electricity markets

In this paper we report the findings of an economic experiment that examines the effects of an automated mitigation procedure (AMP) on prices and capacity investment choices of suppliers in a wholesale electricity market. Specifically, we examine the effects of different market power incentives on markets with and without an AMP. While we find that the AMP does not affect overall investment in capacity, the most significant determinant of long-run prices is investment in new capacity. The AMP also does not reduce long-run prices relative to markets without an AMP. Furthermore, our participants successfully manipulated the AMP’s trigger price. The data and a sample copy of the instructions are available upon request. This article reflects the opinions of the authors and does not necessarily reflect the position of the Federal Energy Regulatory Commission or any individual Commissioner.     

Should merchant transmission investment be subject to a must-offer provision?

Merchant electricity transmission investment is a practically relevant example of an unregulated investment with monopoly properties. However, while leaving the investment decision to the market, the regulator may decide to prohibit capacity withholding with a must-offer provision. This paper examines the welfare effects of a must-offer provision prior to the capacity choice, given three reasons for capacity withholding: uncertainty, demand growth and pre-emptive investment. A must-offer provision will decrease welfare in the first two cases, and can enhance welfare only in the last case. In the presence of importer market power, a regulatory test might be needed.      

Pricing flexibility under rate-of-return regulation: Effects on network infrastructure investment

When a commodity market relies upon a regulated network service industry—e.g., telecommunications, electricity, or natural gas transmission—economic efficiency in that commodity market is a crucial consideration for regulatory design. This is because insufficient infrastructure investment relative to network demand results in congestion. The extraction of associated rents has distortionary effects on commodity spot market prices. Greater regulatory flexibility in network pricing can alleviate such issues by cultivating the incentives needed for stakeholders to invest in transmission capacity. To illustrate this effect I derive and numerically solve stylized optimality conditions for access and usage prices for a gas pipeline operator under alternative regulatory models. My results have general implications for regulation in network infrastructure industries, as energy and telecommunications markets are expected to expand considerably over the coming decades.     

Determinants of the premium in forward contracts

Whilst the benefits of forward contracting for goods and services have been extensively researched in terms of mitigating market power effects in spot markets, we analyse how the risk in spot price formation induces a counteracting premium in the contract prices. We consider and test a wide-ranging set of propositions, involving fundamental, behavioural, dynamic, market conduct and shock components, on a long data set from the most liquid of European electricity forward markets, the EEX. We show that part of what is conventionally regarded as the market price of risk in electricity is actually that of its underlying fuel commodity, gas; that market power has a double effect on prices, insofar as it increases spot prices and induces a forward premium; that oil price sentiment spills over and that the premium reacts to scarcity and the higher moments of spot price uncertainty. We observe that considerations of the scale and determinants of the forward premium are at least as important as the market power effects in spot market price formation when evaluating the efficiency of wholesale power trading.     

Cross market predictions for commodity prices

This paper shows that commodity prices can be predicted from cross-market information by establishing long-run cross-market commodity price equilibrium models, which are characterized by a linear relation between prices across different markets. Using data from five representative commodity markets (oil, copper, gold, corn, and cattle) during the period 2005–2018, we demonstrate that oil and industrial metal markets have formed a long-run price equilibrium with other markets across different commodity families. However, agriculture and gold markets do not tend to have long-run price equilibrium relations with other commodity markets. Furthermore, we show that the absence of a price equilibrium is due to the cross-market liquidity interference effect. After we control for the liquidity effect, long-run cross-market commodity price equilibrium relations are reestablished for agriculture and gold markets. These results can aid in demonstrating that liquidity can capture most of the missing information that is not reflected in price dynamics in less liquid markets, such as agriculture and gold markets. Therefore, less liquid commodity price predictions require both prices and liquidity levels from cross-markets, while liquid commodity prices (oil and metal) can be predicted based solely on cross-market prices.     

Appropriate contract durations in the German markets for on-line reserve capacity

This paper explores the economic implications of different contract durations in markets for on-line (primary and secondary) reserve capacity in Germany with the crucial feature of separate markets for spot energy and reserve capacity provision. The analysis is based on an equilibrium model developed by Just and Weber (Energy Econo 30:3198–3221, 2008) for reserve markets. It reveals the implicit trade-off for the bidders and implicit interdependencies between the reserve and the spot markets. Even if the markets are not explicitly coordinated, they are interrelated through the dispatch decisions of the power plant owners. The paper concludes that the current German reserve market design is inefficient and should be improved. The results clearly show that shorter periods (with resulting lower variations in overall electricity demand) lead to more efficient dispatch and market results. Not only prices in the reserve capacity markets are expected to be lower, but also spot market prices. As these benefits can be partially reaped by owners of large generation portfolios also under longer contract durations, it discriminates against smaller generation companies and can potentially deter market participation. Further, the paper takes a broader perspective and discusses security concerns against shorter contract durations. It is shown that the opportunity costs character of the reserve market implies sufficient incentives for supplying online reserve capacity. The concerns do not appear to be predominant and it should be possible to manage them appropriately.     

The impact of electricity prices on foreign direct investment: evidence from the European Union

We examine the impact of electricity price variation on net FDI (%GDP) inflows in countries of the European Union. We use panel data of 27 EU countries for a period of 2003 – 2013. We show that electricity prices of south-western and north-eastern EU countries did not converge to one price until now. Dynamic panel data analysis using system GMM shows that besides unit labour costs, tax rates and competitive disadvantage in secondary education, also higher electricity prices reduce countries’ ability to attract FDI. The immediate effects are statistically significant across both sub-regions analysed: in the short run, a 10% increase in electricity prices leads to a decrease in net FDI inflows as a share of GDP by 0.4 percentage points for the south-western and 0.33 for the north-eastern region. In the long run, the response is 0.60 percentage points for south-western and 0.48 for north-eastern regions. Policies should aim at reducing electricity market price differences on the European level through investment in transborder transmission capacity; reductions in FDI, when environmental policy increases after-tax electricity prices, should be countered by other tax reductions as well as harmonization of property rights, absence of corruption and labour market regulations at best-practice level.     

The Relevant Market for Production and Wholesale of Electricity in the Nordic Countries: An Econometric Study*

We apply cointegration analysis to daily averages of Nord Pool prices covering the period 2001–2007 in order to empirically characterize the geographical dimension of the relevant market for production and wholesale of electricity. We reach the following econometric conclusions: (i) price areas Finland, Sweden, and Norway 3 unambiguously belong to the same relevant market; (ii) Denmark 2 belongs to this same market except for the subsample 2004–2007; (iii) Norway 1 and Denmark 1 define separate markets on their own. We find that the stochastic trends in Nord Pool prices originate in countries abundant in capacity to generate hydro power.     

Price Discrimination, Regulation and Entry in the UK Residential Electricity Market

The residential electricity market in Great Britain has recently been opened to competition and is served by 14 regional incumbents, and up to 15 entrants in each area. This study finds that the incumbents' regulated prices are discriminatory between consumers using different payment methods, and that firms are practising third‐degree price discrimination between areas. The authors discuss the implications for regulatory policy both in the UK and in other countries where electricity markets are being deregulated.     

The Impact of the EU ETS on Prices,Profits and Emissions in the Power Sector: Simulation Results with the COMPETES EU20 Model

This paper analyses the impact of the EU Emissions Trading Scheme (ETS) on electricity prices, in particular on wholesale power markets across the EU. To study this impact, this paper discusses the major results of a bottom-up modelling analysis of the implications of emissions trading for the performance of the wholesale power market in 20 European countries. The analyses show that a significant part of the costs of (freely allocated) CO₂ emission allowances is passed through to power prices, resulting in higher electricity prices for consumers and additional (‘windfall’) profits for power producers, even in cases of full auctioning. In addition, they show that the ETS-induced increases in power prices depend not only on the level of CO₂ prices but also on the structure of the power market, i.e., the incidence of market power, and the price responsiveness of power demand. Finally, the analyses show that the internalization and pass-through of carbon costs are crucial elements in a policy regime to reduce CO₂ emissions by both changing the mix of power generation technologies and lowering total electricity demand.     

Are Commodity Prices Driven by Fundamentals?

Physical scarcity is hardly sufficient to explain commodity price swings. However, despite of clues of commodity market inefficiency in the last decade, excess volatility in commodity markets emerges only under strong assumptions. When we allow for non‐stationarity in commodity prices and time variation in commodity‐specific risk premia, evidence of commodity market inefficiency becomes significantly weaker. Moreover, there is some evidence of commodity‐specific regime changes in commodity markets, with negligible or even positive correlation between efficiency and market liquidity.     

Price effects of independent transmission system operators in the United States electricity market

In 1996, the Federal Energy Regulatory Commission (FERC) sought to “remove impediments to competition in the wholesale bulk power marketplace and to bring more efficient, lower cost power to the Nation’s electricity consumers” through a series of market rules. A product of these rules was the establishment of regional transmission organizations (RTOs) and independent system operators (ISOs) charged with facilitating equal access to the transmission grid for electricity suppliers. Whether these changes in market structure have succeeded in achieving FERC’s goal to provide “lower cost power to the Nation’s electricity consumers” remains an open question. This paper utilizes a panel data set of the 48 contiguous United States and a treatment effects model in first differences to determine whether there have been changes in delivered electric prices as a result of the establishment of ISOs and RTOs. To avoid the confounding effects of electric restructuring, the model is estimated with the full panel data set, and then again without the states that have restructured their electric markets. This estimation shows that electricity prices fall approximately 4.8 % in the first 2 years of an ISO’s operation and that this result is statistically significant. However, this result is dependent on the presence of states that restructured their electricity markets. When these restructured states are removed from the data set the price effects of RTOs become indistinguishable from zero. The paper concludes that rate agreements are the principal source of the observed decrease in prices and that RTOs have not had the desired effect on electricity prices.     

Stability of supply function equilibria implications for daily versus hourly bids in a poolco market

We consider a supply function model of a poolco electricity market where demand varies significantly over a time horizon such as a day and also has a small responsiveness to price. Although there are equilibria yielding prices at peak that are close to Cournot prices, it is known that the wider the range of demand uncertainty the narrower the range of such supply function equilibria. Here we show that such equilibria are also typically unstable and consequently would be difficult to sustain in practice. This strengthens the results of Green and Newbery by ruling out many equilibria that have high prices. We demonstrate this result both theoretically under somewhat restrictive assumptions and also numerically using both a three-firm example system and a five-firm example system having generation capacity constraints. Hence, this reinforces the conclusion that the market outcome is significantly influenced by a requirement that offers into the poolco be consistent over the time horizon. This result contrasts with markets where bids can be changed on an hourly basis, where Cournot prices are possible outcomes. The stability analysis has important policy implications for the design of day-ahead electricity markets. The stability perspective also provides a narrowing of the equilibrium selection that strengthens empirical analysis.      

The influence of investment experience on market prices: laboratory evidence

We run laboratory experiments to analyze the impact of prior investment experience on price efficiency in asset markets. Before subjects enter the asset market they gain either no, positive, or negative investment experience in an investment game. To get a comprehensive picture about the role of experience we implement two asset market designs. One is prone to inefficient pricing, exhibiting bubble and crash patterns, while the other exhibits efficient pricing. We find that (i) both, positive and negative, experience gained in the investment game lead to efficient pricing in both market settings. Further, we show that (ii) the experience effect dominates potential effects triggered by positive and negative sentiment generated by the investment game. We conjecture that experiencing changing price paths in the investment game can create a higher sensibility on changing fundamentals (through higher salience) among subjects in the subsequently run asset market.     

Investment dynamics in electricity markets

We investigate the incentives for investments in capacity in a simple strategic dynamic model with random demand growth. We construct non-collusive Markovian equilibria where the firms?? decisions depend on the current capacity stock only. The firms maintain small reserve margins and high market prices, and extract large rents. In some equilibria, rationing occurs with positive probability, so the market mechanism does not ensure ??security of supply??. Usually, the price cap reflects the value of lost energy or lost load (VOLL) that consumers place on severely reducing consumption on short notice. Our analysis identifies a minimum price cap, unrelated to the VOLL, that allows the firms to recoup their investment and production costs in equilibrium. However, raising the price cap above this minimum increases market prices and reduces consumer surplus, without affecting the level of investment.     

Asset Markets and Endogenous Liquidity

In financial markets characterized by imperfect depth, speculative trading will have transitory effects on the market price as market makers must be compensated for the risk of holding the asset. The number of people providing liquidity to a market will generally be endogenously determined by the quantity of liquidity demanded. This paper looks for evidence of endogenous liquidity provision in several international stock and bond markets. Evidence shows strong support for these speculative dynamics in the stock markets. The evidence for these dynamics is less striking with fixed‐income prices, consistent with the less speculative nature of these markets.     

Pricing and price competition in consumer markets

This paper offers a simple model of the price mechanism in markets where buyers take prices as given and prices are set by sellers, as in most consumer markets. It explains price competition by arguing that a market price goes down if—and only if—a price cut appears profitable to a firm even if its competitors follow suit. It also explains why markets do not always clear, that is, why production can be restricted by sales and not capacity at prices set by firms.     

Financial frictions and the futures pricing puzzle

In perfect capital markets, the futures price of an asset should be an unbiased forecast of its realized spot price when the contract matures. In reality, futures prices are often higher for some assets and lower for others. However, there is no stability in the relationship between futures prices and the realized spot prices. This instability has been a puzzle in the existing financial literature. The key to this puzzle may lie in the nature of the model and the lack of market imperfections. In this study, we take a theoretical approach in a dynamic multi-period environment. We incorporate competition between disparate economic agents and impose financial frictions (i.e., imperfections) that are in the form of hedging and borrowing limits on them. Our model gives rise to multiple equilibria, each with unique market clearing prices, with the market switching between these equilibria. Our analysis incorporates a comprehensive consideration of the risks faced by the futures markets participants (i.e., speculators and hedgers) and leads to a better understanding of the puzzle.     

The effect of the National Food Reserve Agency on maize market prices in Tanzania

Tanzania's National Food Reserve Agency has a mandate to ensure food security through procuring, reserving and recycling grain (primarily maize) in a cost‐effective manner. This mandate excludes a price stabilization role. Procurement prices, based on production costs, are often set above market prices to encourage production. Several disbursements channels exist: grain provided free or at a discount to targeted vulnerable households; subsidized sales to millers; and sales to prisons or nongovernmental aid programs, typically at market‐related prices. Given the perception that these activities are distortive, we use time‐series econometrics to model maize price dynamics in select wholesale markets to capture the Agency's market impact. We find that its pricing strategy had an insignificant impact on prices during 2010/11–2014/15 despite a fairly significant presence in at least some regional markets. We recommend that the Agency reconsiders offering a price premium on procured maize or selling maize at discount to millers, as limited market spill‐over effects imply the benefits are captured by only a few, even though its practice of providing subsidized or free maize to vulnerable people is not in question. Furthermore, current storage capacity expansion plans are not required and inconsistent with its food security mandate.     

Politics,institutions, and outcomes: Electricity regulation in Argentina and Chile

Risk, whether market or political, is an important determinant of private investment decisions. One important risk, subject to control by the government, is the risk associated with the hold-up problem: governments can force utilities to shoulder burdensome taxes, to use input factors ineffectively, or to charge unprofitable rates for their service. To attract private investment governments must be able to make commitments to policies that are nonexpropriative (either to contracts that guarantee very high rates of return or to favorable regulatory policies). These commitments, of course, must be credible.

Judgments about the credibility of commitments to regulatoty policies are based upon two political factors: regulatory predictability and regime stability. Regulatory predictability implies that the regulatory process, in which prices and levels of service are set, is not arbitrary. If the condition of regulatory predictability holds, then investors can forecast their returns over time and hence can calculate the value of their investment. If there is regime stability, then there is minimal risk of wholesale changes in the way the government regulates the industry—the most extreme type of change being the denial of property rights, or expropriation. We argue that three characteristics of the regulatory process are, in turn, important determinants of regulatory predictability: agenda control, reversionary regulatory policy, and veto gates. Moreover, regime stability is also, in part, a function of these three characteristics. We examine our theory of political risk and regulatoty commitment by comparing the cases of Argentine and Chilean electricity investment and regulation.