Market power1 ECON 4925 Autumn 2007 Electricity Economics Lecture 10 Lecturer: Finn R. Førsund

Market power 2 Hydro and thermal Thermal plants aggregated by merit order to a convex group marginal cost function Total capacity is limited Static problem: no start-up costs, no ramping constraints or minimum time on – off Hydro power plants aggregated to a single plant

Market power 3 Monopoly problem with hydo and thermal plants

Market power 4 Solving the optimisation problem The Lagrangian function (eliminating total consumption)

Market power 5 Solving the optimisation problem, cont. The Kuhn – Tucker conditions

Market power 6 Interpreting the optimality conditions Assumption: both hydro and thermal capacity is used Flexibility-corrected price equal to water value equal to marginal thermal costs (plus shadow value on the capacity constraint) Same amount of thermal capacity used in each period

Market power 7 Monopoly and extended bath-tub c’ λMλM Hydro energy p2Mp2M Period 1 Period 2 p1Mp1M Thermal extension a A B c C D d

Market power 8 Hydro with competitive fringe Thermal fringe modelled by a convex marginal cost function with limited capacity The fringe is a price taker and sets market price equal to marginal cost The dominant hydro firm must take fringe reaction into consideration Market power is reduced due to the fringe Conditional marginal revenue curve closer to demand curve due to market share less than 1 and fringe quantity adjustment

Market power 9 The optimisation problem of the dominant hydro firm

Market power 10 The reaction of the competitive fringe Finding the reaction of the fringe to the quantity of the dominant firm  Solving for thermal output as a function of hydro output

Market power 11 The reaction of the competitive fringe, cont Determining the sign of the reaction function  Differentiating the behavioural condition

Market power 12 Solving the optimisation problem of the dominant hydro firm The Lagrangian function The Kuhn – Tucker conditions

Market power 13 Interpretations Signing of the expression (1 + de t Th /de t H )

Market power 14 Interpretations, cont. Decomposition of conditional marginal revenue Conditional marginal revenue curve closer to demand curve due to  Market share less than 1  Fringe reaction of increasing output when price increases

Market power 15 A constraint on fringe thermal capacity Advantage for the dominant firm when fringe capacity constraint is biting  Limit on the fringe quantity reaction  Fringe response

Market power 16 The leader – follower game θ2θ2 p2p2 c’ p1p1 Thermal fringe λ λ A B C D E Hydro energy c’ Period 1Period 2

Market power 17 Extentions Hydro as competitive fringe  Hydro fringe can release all water just in one period, may restrict market power further Oligopoly game between hydro producers  Essentially a dynamic game, reduces the possibilities of strategic shifting of water  Quite complex to find solutions to dynamic gaming Uncertainty  Future water values become stochastic variables, system must avoid overflow or going dry, qualitatively the same problem for social planner and monopoly

Market power 18 Conclusions Hydro monopoly shifts water from relatively inelastic periods to elastic ones May be difficult to detect because variable cost is zero, only alternative value of water is variable cost and not readily observable Reservoir constraints, production constraints, etc. reduce the impact of market power Competitive fringe may block use of market power Fear of hydro market power exaggerated?