Environmental Regulation in Oligopoly Markets: A Study of Electricity Restructuring Erin T. Mansur UC Berkeley and UC Energy Institute March 22, 2002 POWER Conference

2 Pennsylvania, New Jersey, and Maryland Electric Utility Emissions SO 2 down 12% in 1999NO x down 17% in 1999 PJM Electricity Restructuring –Change Firm Incentives Environmental Regulation –New marginal cost (OTC NOx Tradable Permit Market)

3 Research Questions If so, what are the welfare losses and environmental consequences? What are the policy implications of these effects? Did restructuring the PJM electricity market enable firms to exercise market power?

4 The PJM Electricity Market Structure of market –Integrated with eastern grid –Summers 98-99: no major structural change –Six main firms vertically integrated Generation, transmission, and distribution Imperfect integration (net positions in market) –Highly inelastic demand PJM wholesale spot market –PJM interconnection established in March, 1997 Required firms to bid “cost-based” –Rule changes in “nodal” market –April 1999: started “market-based” bids

5 PJM Market-wide Marginal Cost Curve

6 High Demand

7 PJM Market-wide Marginal Cost Curve Low Demand

8 Cross-firm Production Inefficiencies: Implications for PJM Vs. California PJM –Marginal fuel types: coal, oil, or natural gas –Dominant firms reduce output from their most expensive operating unit (often coal) –Fringe firms produce more from even more expensive units (often gas) –Exercising market power reduces emissions California –Marginal fuel: only natural gas –Dominant firms reduce from cheaper, cleaner units –Exercising market power increases emissions

9 Technique Simplified model –Determine the perfectly competitive price by Constructing MC curve (produce at full capacity if P>MC) Estimating residual demand from net import responses Intertemporal model –Firms face intertemporal constraints Min and max operating capacities Starting up costs Ramping rates and minimum down time –Optimize w.r.t. more than just current hour’s price –Econometric model of firm production based on competitive behavior pre-restructuring Compare actual and competitive counterfactual

10 Market imperfections increased the cost of power purchases in the spot market by 41% in the summer of 1999 Substantial price-cost margins at average demand levels Market Power: Price-Cost Margins

11 Market Power: Firm-level Analysis Firm incentives –Price elasticity of residual demand –Net position (generation less load) –Contract position PECO and PPL exercise market power –Positive correlation price-cost margin and net position –Consistent with incentives

12 Welfare Implications From Production Inefficiencies Comparing summer 1998 to summer 1999 Actual production costs: $1.7 to $2.1 billion Intertemporal competitive model –Costs increased - $275 million –Welfare loss - $158 million –About 8% of competitive cost estimates Simplified competitive model –Ignore intertemporal constraints –Welfare losses - $387 million

13 Hourly Average Tons of Emissions in PJM 41% Market Imperfections 14% Market Imperfections Value of permits saved Aggregation of (Daily Price * Emissions Change) $6.2 million from SO 2 reductions $6.7 million from NO x reductions

14 Environmental Policy Implications Permit prices may be endogenous, but not taxes PJM case –Reduce permit demand –Reduce dominant firms’ costs by more –Preference for cap - feedback effect California case –Increases fringe’s costs by more –Preference for cap - feedback effect Pollution taxes vs. tradable permits in second- best setting

15 Conclusions Evidence of Market Power by Net Selling Firms Welfare Effects from Market Imperfections –Market power increased production costs by $160 million –DWL is 8% of total production costs Environmental Effects from Market Imperfections –41% of SO 2 reductions; 14% of NOx Reductions; $13 M Policy implications –Tradable permits mitigate market power, and may lead to greater welfare than using environmental taxes