First Lecture: Part 2 Strategic Evolution of Competitive Electricity Markets

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First Lecture Part 2Strategic Evolution of
Competitive Electricity Markets

• Derek W. Bunn
• London Business School

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The globalisation of energy markets is having an
effect on price convergence

• Global Markets for Fuels Oil, Coal, LNG
• Global Energy Businesses replacing National
  Utilities
• International Capital Markets and Multinational
  Investors
• Market Liberalisations and Harmonisations
• Regional Interconnections

But rather less than we would expect
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EU Industry Prices still show substantial
disparity..
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So, what do we now know about the evolution of
power markets?

• Dynamic Evolution
• Initial thoughts that global markets would be a
  strong convergent driver have not been upheld
• Local Factors, Market Structure and
  Strategic Behaviour may be more important.

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Local Fundamentals

• 1. Link to fuels

UK Monthly Forward Prices
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Local Fundamentals The Supply Stack Links Fuels
to Prices

• The Stack is produced from the Generators
  Offers to the market
• But would the Generators offers be cost
  reflective?

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Notice the High Volatility During the Price-Cap
Period.
Time Weighted Average Monthly Pool Prices
24 Average Price Cap
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The Increase in Price Volatility...
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. was achieved through changing the supply
function.
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Local Fundamentals

• 1. Link to Fuels
• 2. Supply and Demand Balance

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Sensitivity of Prices to Reserve Margin

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California Reserve Margin Declined Steadily.
Margin
Deregulation
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And at a critical point, spikes began to emerge
CAL Hourly wholesale power prices ( /MWh )
WSCC
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Local Fundamentals

• Fundamental link to Fuels
• Reserve Margin
• Market Structure and Conduct

New Game
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Changing Ownership of Coal (ie price-setting)
Plant(Source John Bower)
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The Growth of Vertical Reintegration
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Residential
Price Index
Full Retail Opening
Wholesale
Vertical Integration Immunised against Wholesale
Price
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Value moved to the Least Elastic part of the
Supply Chain Prices Paid for Residential Assets
(/Domestic Customer)
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With a Drop in Value of Generating Plant
CCGT Resale Prices /kW
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Re-Concentration follows distress
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90 of Retail now delivered by Top 6 Suppliers
Source Power UK March 2005
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65 of England and Wales Generation Produced by
Top 6 Suppliers
Source IPA Energy
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Prices Moved Up
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Large Generators Returned some Capacity
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These Basic Divers Appear in Price Models

• Fundamental link to Fuels
• Reserve Margin
• Market Structure and Conduct
• Eg. Monthly Price Model (1990-2002) by Evans
  Green
• Price (Lerner) a b1 Herfindahl
• b2 Herfindahl2
• b3 Demand/Capacity
• b4 Sept2000
• (R2 67)

And their effects are Cyclical
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What do we now know about the evolution of power
markets?

• Dynamic Evolution
• Initial thoughts that global markets for fuels
  would be a strong convergent driver have not
  been upheld
• Local Factors, Market Structure and
  Strategic Behaviour may be Pro-cyclical.
• 2. Value can migrate up and down the supply chain
• Retail can capture value more effectively than
  wholesale

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What do we now know about the evolution of power
markets?

• Dynamic Evolution
• Initial thoughts that global markets for fuels
  would be a strong convergent driver have not
  been upheld
• Local Factors, Market Structure and
  Strategic Behaviour may be pro-cyclical.
• 2. Value can migrate up and down the supply chain
• Retail can capture value more effectively than
  wholesale
• 3. Governments are beginning to prefer imperfect
  markets
• A few large, vertically integrated companies
  provide security and can be managed.

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. and many countries explicitly pursue the
national champion objective.
EU GENERATION CAPACITY CONCENTRATION RATIO (3
FIRM) 2001
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What do we now know about the evolution of power
markets?

• Dynamic Evolution
• Initial thoughts that global markets for fuels
  would be a strong convergent driver have not
  been upheld
• Local Factors, Market Structure and
  Strategic Behaviour may be pro-cyclical.
• 2. Value can migrate up and down the supply chain
• Retail can capture value more effectively than
  wholesale
• 3. Governments are beginning to prefer imperfect
  markets
• A few large, vertically integrated companies
  provide security and can be managed.
• 4. Imperfect Markets will exhibit Dynamic
  Strategic Behaviour
• Prices will not stabilise at marginal costs

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Even after 7 years of daily evolution, the supply
function was not stable.
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The following days continue to show dynamic
learning and gaming.
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What do we now know about the evolution of power
markets?

• Dynamic Evolution
• Market Structure and Strategic Behaviour may
  be Pro-cyclical.
• 2. Value can migrate up and down the supply chain
• Retail can capture value more effectively than
  wholesale
• 3. Governments are beginning to prefer imperfect
  markets
• A few large, vertically integrated companies
  provide security and can be managed.
• 4. Imperfect Markets will exhibit Dynamic
  Strategic Behaviour
• Prices will not stabilise at marginal costs
• 5. Regulatory Risk is inevitable and substantial

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Further Reading

• Sally Hunt
• Making Competition Work in Electricity (Wiley,
  2002)
• Steven Stoft
• Power System Economics (Wiley, 2002)
• Alexander Eydlund and Krzysztof Wolyniec
• Energy and Power Risk Management (Wiley, 2003)
• Derek Bunn
• Modelling Prices in Competitive Electricity
  Markets (Wiley 2004)