0IERCUInstitute of Economic Research, Chuo University

Discussion Paper No.192

Structural Changes of the Electricity Market in Japan:
A Theoretical Perspective of Consumers’ Eco-friendly Behaviour
Kimihito ISE
Japan Electric Power Information Centre, Inc.
&
Masahiro YABUTA
Faculty of Economics, Chuo University
September 2012

IERCU Discussion Paper

INSTITUTE OF ECONOMIC RESEARCH
Chuo University
Tokyo, Japan

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Structural Changes of the Electricity Market in Japan:
Theoretical Perspectives of Consumers’ Eco-friendly Behaviour
Kimihito ISE*
Research Director
Japan Electric Power Information Center, Inc.
15-33, Shibaura, 4-chome, Minato-ku, Tokyo, 108-0023, Japan
E-mail: ise-kimihito@jepic.or.jp
Masahiro YABUTA*
Faculty of Economics
Chuo University742-1 Higashinakano, Hachioji, Tokyo, 192-0393, Japan
E-mail:yabuta@tamacc.chuo-u.ac.jp
ABSTRACT
After the Fukushima-Daiichi accident of atomic power stations in 2011, drastic changes of theelectricity market in Japan have occurred; a tendency towards promoting renewable energies such as
solar power and wind power, and a structural change of the electricity market from regionalmonopoly to competition. As far as a market structure is concerned, not only its structural change
towards competitiveness but also the energy development towards renewable power sources which
consumers can choose to follow their choice behaviour are important. This paper analyses thewelfare aspects of the structural changes of electricity market in Japan, mainly from theoretical
viewpoints. Modellingthe changing pattern of Japanese electricity market

consists of three

dimensions; firstly, the Beltrand competitive market where consumers freely choose a traditional
thermal power or a renewable power. Secondly, markets where consumers can partially choose apower source due to a green-energy program. Thirdly, a regional monopolistic market where a
regional monopoly such as Tokyo Electric Power Company (TEPCO) provides electricity andconsumers has no choice among energy-sources. Actually, the development pattern of the Japaneseelectricity market has moved from the third and will change to the first. For each dimension, theverticaldifferentiation models

are applied in which consumers’ environmentally friendly

behaviour expresses their willingness to pay for the renewable-energy sources. Major concern of thepaper is consumers’ welfare aspects corresponding to the development pattern of electricity market
in Japan.
Key words: Product differentiation, Electricity market, Renewable resources, Consumers’
Eco-friendly behaviour
Category & Number: 10
JEL Classification Code: L15; L94; Q20;
* The views and opinions expressed here are their own, and not those of other people, institutions with which they
are affiliated.

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1.

Introduction
This paper analyses the consumers’ welfare aspects when they choose energy sources in theelectricity market in Japan. After the Fukushima-Daiichi accident of atomic power stations in 2011,
drastic changes of the electricity market in Japan have occurred; a tendency towards promoting
renewable energies such as solar power and wind power, and a structural change of the electricity
market from regional monopoly to competition. As far as a market structure is concerned, not only
its structural change towards competitiveness but also the energy development towards renewable
power sources which consumers can choose to follow their choice behaviour are important. This
paper examines the effects of the structural changes of electricity market in Japan on the prices, theshare of various power sources, and consumers’ welfare, mainly from theoretical viewpoints.
Currently, a regional monopoly such as TEPCO has occupied the integrated system of power
generation and transmission in Japan. Hence, whereas TEPCO can choose its desirable power source
as a mix of hydro, thermal, nuclear and renewable power, its consumers can neither help using theelectricity of mixed power source provided by TEPCO without choosing a power source among themixed sources. From a perspective of eco-friendly consumers’ behaviour, for example, it isimportant whether what they consume is generated by eco-friendly, renewable-energy source or not.
Debates of the electricity market reform in Japan have occurred with respect to the consumers’possibility to choose the green energy or traditional fossil energy, which inevitably leads to a reformof the market structure and its drastic change in the near future. Accordingly, major concern of thepaper is the welfare aspects of consumers corresponding to the development pattern of electricity
market in Japan.
Modelling the changing pattern of the Japanese electricity market includes three dimensions;firstly, a competitive market where consumers freely choose a traditional thermal power or arenewable power. Secondly, a market where consumers can partially choose power source thanks to3

a green-energy program. Thirdly, consumers have no choice between mixed energy-sources which a
regional monopoly such as Tokyo Electric Power Company (TEPCO) provides, at present situation.
Actually, the development pattern of the Japanese electricity market has moved from the third andwill change to the first. For each dimension, a vertical differentiation model is applied in which
consumers’ environmentally-friendly behaviour expresses their willingness to pay for the
renewable-energy sources and some policy measures are incorporated. In these dimensions, thepaper analyses how the above-mentioned changes affect the electricity market, power source share,
consumer surplus and environmental damage. In our analysis, we firstly evaluate the equilibrium in acompetitive electricity market where consumers can freely choose a power source. After that, we
compare the competitive equilibrium and the equilibrium that various regulatory frameworks bring.
In this connection, regulatory measures of electricity market such as feed-in tariff, renewable
portfolio standards and green electricity program are investigated. To simplify the model analysis of
the development pattern of market structure, a model of product differentiation where electricity
consumers have a different willingness to pay is employed.
The composition of the paper is as follows: Section 2 gives a brief history of the recent
development of Japanese electricity market, in particular, focusing on changes of its supply structure
and power-source components. Development process of Japanese electricity markets can beclassified into three dimensions from a schematic view: a monopoly in which green consumers haveno choices among power sources, a semi-competition between the duopolistic firms with different
power sources such as fossil-energy and solar-energy, and a competition between firms in whichgreen consumers can choose a green power source regarding their willingness to pay for the green.
Section 3 reviews preceding works about the vertical differentiation of the products, mainly from thetheoretical perspectives. Shaked and Sutton (1982) and Moorthy (1988), for example, developed agame theoretic vertical differentiation model to examine firm’s strategic behavior of decision making

4

concerning its product’s quality. More recently, Cremar & Thisse (1999), Ripiinen (2005), Andre etal. (2009), Toshimitu (2010) and Lanbertini & Tampieri (2011) analyzed vertical differentiation
models to examine the characteristics of the equilibrium in Cournot or Bertrand competition, andinvestigated the effectiveness of tax or subsidy to improve the social welfare. Assumptions of theheterogeneity of consumers’ choice between high (green) and low (brown) production technology(or products) led to various conclusions depending upon both the market condition and theconsumers’ choice behavior. Applying their theoretical aspects of vertical differentiation, duopolisticcompetition and consumers’ green choice to the development process of Japanese electricity market,
Section 4 examines how changes of the institutional design of the electricity market in Japan lead tothe different outcomes concerning the social welfare. In this connection, the policy implications ofpromoting renewable power sources in the Japanese electricity market will be investigated. Finally,in Section 5 summarizes the conclusions and further remarks.

2. Electricity Market in Japan
After the World War II, ten privately-owned electric power companies including Okinawa ElectricPower have established. Currently, they are in charge of regional power supply services and are
responsible for generating electricity and distributing it to the consumers in their respective service
area allocated by the government policy. While the regional monopoly has been maintained, theelectric power market in Japan itself has been slightly liberalized when the independent power
producers (IPPs) were allowed to participate in the electricity wholesale electricity market in 1995.
Then, the transmission/ distribution network owned by the electric power companies became open
access in March 2000, and the retail market was partially liberalized to allow power producers andsuppliers (PPSs) to sell electricity to extra-high voltage users requiring more than 2MW. The scopeof liberalization was expanded in April 2004 to users requiring more than 500kW, and subsequently

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in April 2005 to users requiring more than 50kW. Accordingly, by 2011, the scope of liberalization
covers approximately 60% of total electricity demand in Japan. In spite of such liberalization, theactual share of power generation by newcomers was only less than 1% in 2010.
Along with the effort for making the market competitive, Japanese government has also
introduced measures to increase use of renewable energies in the electricity sector. From April of2003 to the end of June of 2012, a Renewable Portfolio Standard (RPS) policy had been
implemented, which mandated the electricity retailers to use renewable energies of a certain
percentage of their power source. In addition, an excess electricity purchasing scheme, that is socalled the Feed-in Tariff (FIT), was introduced in November 2009. Under the scheme of the FIT, theelectric power companies purchase the surplus energy at a fixed price that photovoltaic power (PV)generators do not use themselves. Since July 2012, electric power companies are obliged to purchaseall power generated by facilities using renewable energy sources such as photovoltaic, small- andmedium-scale hydroelectric, wind, geothermal, and biomass except the residential photovoltaic
power generation systems at fixed prices during a period determined by the government. Currently,
as for PV, the tariff is 42 yen and the duration is 20 years. As for the residential photovoltaic power
generation systems, the excess electricity is being purchased by electric power companies. In thisconnection, RPS was discontinued when the FIT was introduced in 2009.
In addition to various regulatory measures, electric power companies and other entities havevoluntarily launched some incentive measures to encourage consumers to use more eco-friendly
energy such as a green electricity fund and a carbon-offset. For example, an electricity consumer
donates 500yen per month to an electric power company, and it contributes same amounts in order topromote eco-friendly activities such as environmental education at public schools and constructing
power stations sourced by renewable energies. At the end of FY2009, the fund has facilitated around
1% of the total photovoltaic power generation capacity (24MW compared to 2,627 MW). However,6

electric power companies have closed the fund system after the FIT was introduced.
Despite the above-mentioned efforts, the share of electricity production from renewable sources
including hydro was only about10% in 2010. After the Fukushima-Daiichi accident of atomic power
stations in 2011, some advisory bodies to the Japanese government have started discussing an energyplan, and through discussions, the government proposed an energy plan with three scenarios for2030 to the public, and by reflecting the opinions, is trying to formulate a new energy policy by 2012.
Each scenario envisages increasing the ratio of renewable energies to around 25 to 35%. Moreover,the governmental committees are now discussing the electric power system reform, including a fully
opened retail electricity market and a system in which consumers can choose a producer who uses
the eco-friendly renewable energies based on their environment-oriented tastes. The conclusion will
be drawn by the end of 2012. In short, the Japanese electricity market is heading to liberalization, in
which the possibility of consumers’ choice for green power will be guaranteed and the use ofrenewable power sources by generators will be accelerated.

3. A Review
As already mentioned, this paper is concerned about the structure of the Japanese electricity
market, which is determined by competitive situations among firms to produce electricity andconsumers’ choice behaviour among power sources. To identify the market structure in which firms
produce a different quality of goods or use a different technology, there are two types of thedifferentiation model; the horizontal differentiation model and the vertical differentiation model(Lancaster (1979)). Take an example when a consumer purchases a car. Cars have many different
attributes such as design, performance and safety, which are not related to the difference in therelative merits of the products. Even if the price of cars is the same, consumers may choose a
different car because its design is different. Then, the different attributes (design) of consumption

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goods have different consumer, leading to the case of a horizontal differentiation1.
On the other hand, in the vertical differentiation model, all consumers make the same choice if
products were provided in the same price. If there is no difference in the product information that
consumers receive, it will be an endpoint solution. Then, assume that only an environmental attributeis different for cars and there are clear differences in merits or demerits of the products; a green
product and a brown product. In front of the products with the same price, consumers may always
choose a green product because of the environmental superiority. Then, the products are verticallydifferentiated. However, if the price of a brown product is lower than the green product due to a low
production cost, some consumers may choose the brown product. In the vertical differentiation
model, the differences in the merits of products such as the environment will lead to a different
pattern of consumers’ choice. In this case, a (green) consumer chooses an eco-friendly car even if its
price is high, but a (brown) consumer purchases a not eco-friendly car because its price is lower thangreen car. Shaked and Sutton (1982) and Moorthy (1988), for example, developed a game theoretic
vertical differentiation model to examine firm’s strategic behavior of decision making concerning its
product’s quality. More recently, Cremar & Thisse (1999), Ripiinen (2005), Andre et al. (2009),
Toshimitu (2010) and Lanbertini & Tampieri (2011) analyzed vertical differentiation models to
examine the characteristics of the equilibrium in Cournot or Bertrand competition, and investigatedthe effectiveness of tax or subsidy to improve the social welfare. Assumptions of the heterogeneityof consumers’ choice between high (green) and low (brown) production technology (or products) led
to various conclusions depending upon both the market condition and the consumers’ choice
behavior.
Shaked and Sutton (1982) and Moorthy (1988) investigated the firms’ strategy concerning aquality decision of the products using the two-stage game framework. It is investigated that in the1

A pioneering research of horizontal differentiation is Hotelling (1929).

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full market coverage, where the products are provided to all consumers, a Cournot competition may
lead to non-existence of equilibrium (Motta (1993)). In the vertical differentiation model, manystudies assumed the Bertrand competition between firms and the full market coverage. André et al.
(2009) showed that a Bertrand competition between duopolies, when a lump-sum tax was imposedon the brown technology, would make both firms employ the green technology. Lanbertini and
Tampieri (2012) extended the André’s analysis so as to include a Cournot competition with arestriction of production scale. Accordingly, the market structure such as Bertrand competition, thepolicy measures to affect the equilibrium are important in the vertical differentiation models.
Moreover, Cremer et al. (2003), Lombardini-Riipinen (2005) and Bansal (2008) investigated thevertical differentiation models to examine the environmental policies including tax and subsidy inthe presence of green consumers.
Table 1 shows a stream of the recent arguments about the application of the verticaldifferentiation models to various aspects including the products’ coverage in the market, thecompetition among firms and policy measures to attain the social optimality. Applying their
theoretical aspects of the vertical differentiation, duopolistic competition and consumers’ green
choice to the development process of Japanese electricity market, this paper examines theinstitutional design of the electricity market in Japan and analyzes the different outcomes concerning
the social welfare.

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Table 1 A stream of the recent studies on the vertical differentiation analysis
Classification

Authors

Shaked and Sutton (1982)

Motta (1993)

Cremer and Thisse (1994)

Lombardini-Riipinen (2005)

Bansal (2008)

Coverage

Competition

Full
PartialBertrand
Cournot

PartialBertrandPartialBertrand
Cournot

PartialFull

PartialBertrandBertrandBertrand

PolicyRegulation
Tax
Subsidy

Notes-

Assuming two firms and the non-existence of production cost, it is proven that the firms will choose distinct
products' qualities, and that both will enjoy a positive profit at the equilibrium. The intuitive idea behind thisresult is that, as their qualities become closer and closer, the price competition between two firms will reduce
the profit of both firms.

-

The author analyses two types of models of vertical differentiation in order to study the influence of price andquantity competition in the Nash equilibrium solution. The author shows that an optimal productdifferentiation is higher in Bertrand competition rather than in Cournot, because the competition will be fiercer
in Bertrand than in Cournot without differentiation.

Tax

Following a specification introduced by Mussa and Rosen (1978), they show that a uniform ad valorem tax,
where the same rate applies to all variants of the product, lowers both equilibrium qualities, distorts the
allocation of consumers between firms, and lowers the consumer prices of both variants. A small uniform tax
is always welfare improving over the non-tax equilibrium.

Tax, Subsidy

Using the similar theoretical model as Cremer and Thisse (1994) has developed, it examined theeffectiveness of the emission tax, ad valorem tax and subsidy for eco-friendly consumers. Unlike Cremer andThisse (1994), it incorporated the environmental externalities in the analysis. Its main conclusion is that the
combination of a uniform ad valorem tax and an emission tax can lead to the social optimum. It also showedthat the same result is obtained by coupling a uniform ad valorem tax and a subsidy to consumers whochoose the green products.

Tax, Subsidy

Using the approach similar to Lombardini-Riipinen (2005) and assuming a more general variable costfunction, it analyzed effects of ad valorem taxes/subsidies and emission taxes on firms. It showed that the
optimal policy shifts from ad valorem taxes to an ad valorem subsidy as the magnitude of the damage
parameter associated with the environmental externality increases.

André et al .(2009)

PartialBertrandTax

In the similar theoretical framework as of Shaked and Sutton (1982), it extended the model to treat theenvironmental quality as a discrete variable rather than a continuous one. Then, it supported the Porter
Hypothesis in a vertically differentiated duopoly model with Bertrand competition, where firms choose to
adopt the green standard under the regulation policy that a lump-sum tax is levied on the brown technology.

Toshimitsu (2010)

PartialCournot

Subsidy

The author considered the effects of the environmental subsidy on the outside market, i.e., a market with
implicit alternatives for consumers (a bicycle, always green goods, outside the car market both with ecofriendly cars and not). From this idea, it obtained the unique result that the subsidy for clean cars degrades
the environment.

Lambertini and Tampieri (2011)

PartialCournot-

The authors extended the analysis carried out by André et al.(2009), assuming Cournot competition between
firms. The background of their idea is that several car manufacturers are massively investing in R&D, without
the taxation on brown technologies. They indicated that a sufficiently low asymmetry in costs drives firms to
the green outcome without regulations.

4. Model Analysis
4.1 Features of the Model
Considering a historical background of the Japanese electricity market in Section 2, this chapter
examines how to enhance the effective expansion of renewable energies, mainly from the theoretical

10perspectives. The feature of the model utilized here is that it reflects the consumers’ various
willingness to pay for power sources, taking both the cost structure of the producers and the market
structure in the Bertrand competition into consideration. The purpose of this chapter is to construct
the model framework with consumers’ choice behaviour in order to show how the price and theshare of the power sources are determined at the equilibrium, and to analyse what factors affect thesocial welfare. While the electricity cannot be physically differentiated, the model assumed that
consumers have a different willingness to pay for every different power sources for generating
electricity generation such as renewable energy or fossil fuel energy. Hence, the model developed
here features the Bertrand-competition between the thermal power firm and the solar power firm.

4.2 Structure of the Model
As preceding works reviewed in section 3 show, the differences of production methods in termsof the environmental aspects such as CO2 emission will affect the consumers’ choice behaviour
through some sort of process (Bansal (2008), Eriksson (2004), Yabuta and Scott (2010)). The reason
why the eco-friendly goods affect the consumption pattern of consumers is because consumers takethe environmental attributes into consideration when they purchase and use them. Among various
factors affecting the consumer behaviour, the idea of ‘altruism’ must be important. An improvementof the environment that a consumer contributes by purchasing and by using products can enhance theindividual utility of a consumer. This is partly because the consumer can enjoy a good environment,
and partly because he/she can enjoy a kind of reputation from others that he/she has contributed tothe environment (Andreoni (1989), Cornes and Sandler (1994), and Kotchen (2005, 2007)). We
introduced an altruism factor into the model which affects consumers’ choice behaviour.
Assume that a thermal power firm (i=1) and a solar power firm (i=2) compete in the electricity
market. There is so much difference in cost functions of both firms. The typical thermal power firm

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represents economies of scale where the large facilities are needed to supply enough amounts ofservices. The generating capacity is 750 MW-1,350 MW in average2. The average cost of production
is 10-11 yen/ kWh3. In contrast, the generating capacity per site of solar power facilities is muchsmaller. The average generating capacity of mega solar plants to which the Feed-in Tariff is applied,
as of end of July 2012, is around 3MW4. The average generation cost is about 30-46 yen/ kWh5. In
this situation, it is clear that the electricity company utilizes only a thermal generation as a supply
source. However, the reason why solar power facilities are actually generating electricity could bethat there are some policy supports to solar power firms, or there are consumers who highly
appreciate the environmental attributes of the solar power.
4.2.1 Supply of Electricity
With respect to the environmental attribute of each firm, ei denotes efforts on environment, ande1>e2 is assumed. Here the opportunity cost, c, of the solar power firm is assumed to be larger than g,
the thermal power firm’s opportunity cost6. The total amounts of generation are normalized to 1.
Then the profit of each firm is given by
(1)

,

(2)
where x is the generation share of solar power firm, y (= 1 - x) is the generation share of thermal
power firm, pi is the price paid by consumers, and s is a subsidy rate.
4.2.2 Consumption of Electricity

2

The average generating capacity is calculated based on LNG and coal power plants that started to operate in recent
seven years (The Energy and Environment Council (2011))
3
The cost is calculated based on the model plant of coal and LNG as of 2010 of which capacity utilization rate is50-80% (The Energy and Environment Council (2011).
4
Calculation was done based on the data downloaded from Agency for Natural Resources and Energy HP.
5
The figures were calculated based on the model plant of 1.2MW as of 2010 (Cost Review Committee HP)
6
It is also assumed that (1-s) c>g, meaning that the average cost of the solar power firm is actually greater than thethermal power firm to generate 1kw of electricity. The reality is that a solar power firm changes its capacity
utilization to adjust the production, while a thermal power firm adjusts the production by changing its quantities offuel input. This is the reason why the costs (c, e1) of solar power firm are assumed to be larger than those of thethermal power firm.

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At least, from the consumers’ viewpoints, there is no difference in the electricity power generated.
The difference in consumers’ choice behaviour mainly comes from the difference in power sourcesthat each power firm utilizes. It must be important for the consumers whether the power source is theeco-friendly solar or the not-eco-friendly thermal, the latter emitting more CO2 than the solar power.
However, whether consumers can make a choice between solar and thermal is depending on the
structure of the electricity market. Until recently, the market had a structure where consumers
couldn’t choose generation methods freely. Consumers in Tokyo, for example, couldn’t help using
mixed electricity provided by TEPCO without being informed the structure of the power sources. As
described below, the introduction of the green electricity program could allow the consumers tochoose the generation methods partially following their willingness-to-pay. Accordingly, it is notablethat the recent development of the electricity market in Japan will change the market structure
towards making the consumers’ free-to-choose possible. In this connection, it is important that a
consumer who has a sufficiently high willingness to pay for the solar power should know exactlythat the electricity which he/she consumes is generated by the solar power. If the information on
power sources is not available, consumers cannot evaluate their willingness to pay for theenvironment. As long as the information of the solar power is available and a sufficient amount of
the solar power is provided, consumers can choose a power source based on their marginal
willingness to pay. Here, each consumer’s marginal willingness to pay is expressed by(3)
where θ is a consumer’s actual evaluation on ei and assumed to be uniform distribution bounded in. Then the average isand the variance is

In general,

whereas the environmentally-conscious consumers to have a large θ will choose the solar power firm,
the environmentally-unconscious consumers will choose the thermal power firm. In consumer’sequilibrium, we assume that

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where

is the intrinsic utility obtained from a single unit of electricity, irrespective of the variant’sunit emission level, andis the marginal utility of social-related evaluation, which gives

consumers who choose the solar power a sense of satisfaction via social recognition for theircontribution to preserve the environment. If the market structure does not allow consumers to choose
a power source, no difference of their evaluation on power sources occurs. Accordingly, consumers
will choose only the thermal power because of the low price. However, if some subsidies are paid forthe solar power, there may be a case in which one chooses solar power, and the other will choose
thermal power.
4.2.3 Market Structures
Considering the above-mentioned points, in particular, a relationship between the market structure
and the consumers’ free choice of the power sources, the following three types of markets are worth
analysis (see Figure 1).
(1) Consumers know there are two types of power sources. However, the consumers cannot choose
a power source, because only the mixed electricity is supplied. In this market, the objective of
the policy maker is the composition of power sources. In order to enhance the share of solar
power in the total power sources, the FIT or the RPS will be introduced.
(2) Consumers know there are two types of power sources. As in (1), while the mixed electricity
supplied, the consumers can choose solar power under the green electricity program.
(3) Consumers know there are two types of power sources. The consumers can freely and directly
choose one of the power sources according to their willingness to pay for the environment.
From a viewpoint of the consumers’ free choice, the above mentioned classification of theelectricity market is close to the idea of Eriksson (2004). Most of proceeding studies, including
Eriksson, analyse the consumers’ choice between green and brown technologies. Although14

technology substitutions are difficult in the electricity sector, the preferences of consumers can bereflected into the generation mix which consists of thermal, solar power, etc. Assume that production
technology of the firms to generate electricity cannot change flexibly, and there are two types of thefirm; a thermal power firm and a solar power firm. Then, there will be the competition between themto determine the share of power source to generate electricity.

Figure 1 Framework of Model Markets

Case

Choice of Consumers

Condition ofCompetition
between Firms
Regulation ofPrice/ Quota(1)

actually impossible
Bertrand

Regulation ofPrice/ Quota(2)

partly possible

Scheme forIntroducing
Solar Power

Reference Figures

Subsidy for SolarPower
FIT or RPS

Subsidy for Solar
Power
Green Electricity
Program

BertrandFIT or RPS(3)possible

BertrandSubsidy for SolarPower

4.3 Model Analysis
4.3.1 A case where consumers can choose a supplier(Competitive Model: Case (3) of Figure 1)
In this case, while consumers choose a supplier freely in the electricity market, each powersource firm is competing in the market. Thus,

15

(5)
is obtained based on consumers’ behaviour so that the consumers are indifferent between choosing
electricity generated by solar power and thermal power. Hence, the share of demand for solar power
can be given by (6).
(6).

In the model, each power firm has a strategic variable; the price of electricity it supplies. The
analysis is suited to the situation where the demand and supply are determined based on the price asa strategic variable of each firm7. The consumers choose a power source under these prices. In the
Bertrand-Nash competition, the reaction functions of each firm are given by
(7)

,

(8)

,

respectively. From (7) and (8),
(9)

,

and
(10)
are obtained. Then the difference in prices between both power firms becomes(11)
Taking (5), (6) and (11) together leads to(12).

From (12), under the assumption of e1>e2, the condition which enables the solar power to be
consumed becomes (13);(13) Numerator of x*=
7.

The model assumes that each power firm adjusts the electricity price so as to maximize its profit, instead of its
generation level. This is because of the difficulty of the output adjustment of the electricity.

16

where C < 0 under the assumption of the cost function(i.e. (1-s)>g). As a result of the Bertrand
competition, the solar power firm can generate electricity at the shaded portion circled by the curbs
of x=0 and x=1 under the condition of e1>e2 (see Fig-2). Consider the conditions where each powersource is utilized by using (6) and (12). When only the thermal power is utilized, i.e. when no
consumer prefers the solar power to thermal power,holds. On theother hand, when only the solar power is utilized, i.e. when every consumer chooses the solar powerfirm,holds. This means that the difference between prices of solar

and thermal power depends on consumer’s actual evaluation on ei (marginal willingness to pay forei), and on marginal utility of social-related evaluation. For example, the price of the solar power isexpensive compared to the price of the thermal power, the share of the solar power becomes smaller.
In this relation, the expansion of the subsidy rate, s in (12), makes the difference of prices smaller
and the share for the solar power larger.
Fig-2 Bertrand competition and the solar power
e2

x＝0

O

x＝1 e1=e2

e1

4.3.2 A case where consumers can partly choose a supplier(Green Electricity program: Case (2) of Figure 1)
Here let us discuss the case where consumers can partly choose a power source through a green
electricity program. Assume the energy-based green electricity program that is operated in US and17

Europe, and in the green program, consumers can purchase the green power directly from the solar
power firm. As shown in Figure 1, customers mainly purchase a mixed power from the thermal
power firm (hereafter the retail firm) which are obliged to buy some amount of electricity generated
by the solar power firm. Then, consumers’ equilibrium is expressed as
(14)

,

where

is the price of the mix electricity by solar and thermal power8. In (14),whereconsumers are indifferent between purchases of solar and mixed power is obtained:(15).

The demand share for x by the solar power firm and for y by the retail firm is
(16)

,

(17)

.

In the following, let us analyse the equilibrium in which the retail firm is required to utilize acertain amount of the solar power (i.e.

in (18) below under FIT or RPS).

4.3.2.1 Electricity Market in which FIT and Green Electricity Program is introduced
Here, assume that the retail firm purchases electricity from the thermal power firm which belongs
to the same firm group, and is obliged to buy a certain amount of electricity,
higher than, at

, which isfrom the solar power firm through the FIT. In this case, the solar power firm has two

options. One is that the solar power firm supplies electricity to the retail firm. The other is that thefirm supplies electricity directly to consumers who reveal a high marginal willingness to pay. In
order to buy electricity directly from the solar power firm, consumers have to offer p1 higher than
to the solar power firm, leading toresidual of electricity, , at the price of8. Under this condition, the solar power firm supplies ato the retail firm after supplying the electricity x directly

In case consumers fully recognize that the mixed electricity by solar and thermal power is supplied, (14) is rewrittenasand (15) is rewritten as. As a result, electricity consumption share of x is considered to decrease.

18

to the consumers9. In this case, the profit function of the solar power firm is given by(18)
The profit function of the retail firm is given by
(19)

where

is the cost of the thermal power firm assumed in 4.3.1.

cost from the solar power firm.

denotes the purchasey (=1- x) shows the supply share of the retail firm, and thegeneration share of the thermal power firm is expressed as. The price of the retail firm, i.e.,

the price of the mixed electricity by solar and thermal power, is set at.

In the following, the solar power firm (i=1) and the retail firm (i=2) determine each price under
given

and

. As discussed in 4.1, the reaction functions of each firm are

(20)

,

(21)

,

respectively. From (20) and (21), each price at the equilibrium is given as
(22)

(23)

,

and their difference is given as(24)

Taking (16), (17) and (24), the demand share for x and for y is
(25)

}]/

(26)
Taking (23), (24) and

9

,
.

,

We assume here that the purchase price ( ) and quantities ( ) are regulated under the FIT. The reason is that thequantities in addition to the price are regulated in the countries where large amounts of renewable energies are
introduced. Also in Japan, the quantities have to be regulated in the technical reason, for example lack of network
capacities. That’ why we assume the quantities are also fixed.

19

(27)
is obtained. Considering analyses in 4.3.1 and in 4.3.2, it is notable that the price and the quantities
at which the consumers purchase directly from the solar power firm are identical in both cases. In
addition, the price and the quantities at which the thermal power firm of 4.3.1 and the retail firm of
4.3.2 supplies are also identical. The difference is the quantities that the solar power firm supplies.
This is because the solar power firm can supply

in addition to x in 4.3.2.1 where FIT is enforced.

In this case, whereas the quantities that the solar power firm supplies are, the quantities

that the thermal power firm supplies decrease by .
4.3.2.2 Electricity Market in which RPS and Green Electricity Program is introduced
Here, assume that the retail firm (i=2) purchases electricity from the thermal power firm which
belongs to the same firm group, and is required to purchase a certain amount of electricity,(atfrom the solar power firm (i=1) under the RPS scheme10. As in the previous case, the solar

power firm has two options. One is that the solar firm supplies electricity to the retail firm. The otheris that the firm supplies electricity directly to the consumers who express a high marginal
willingness to pay. In this case, the profit functions of the solar power firm and the retail firm aregiven by
(28)
(29)

,
.

From (28) and (29), the reaction functions of each firm are
(30)
(31)

,
,

respectively. From (30) and (31), the prices at the equilibrium and their differences are given as

10

Under the RPS, the retail firms are required to purchase a certain amounts of electricity generated by renewableenergies. In general, the purchase price consists of the competitive price that reflects physical value, and of theenvironmental value. Therefore, we assume here the purchase price consiststhat is the weighted average of p1
and p2, and of m as an environmental value.

20

(32)

(33)

,

(34)

.

Considering (16), (17) and (34) together, the demand shares for x and for y become
(35)

]/

(36)

]
/

Then, the equilibrium prices in 4.3.2.1 and in 4.3.2.2 are shown in Figure 3.
With respect to the reaction function of the solar power firm, there is no difference in both cases.
With respect to the retail firm, the reaction function shifts downwards from (21) to (31). In thisrelationship, whereas the slope of solar power firm in both cases is 2, the slope of the reaction
function of the retail firm is 1/2. Therefore, the decrease of the electricity price of the solar powerfirm is smaller than the retail firm, and the difference of the prices between the solar power firm andthe retail firm is larger in 4.32.1, as shown in (24) and (34). Therefore, the share of the retail firm
becomes larger in 4.3.2.2 than in 4.3.2.1.
Fig.-3 Reaction Functions of Solar Power Firm and Retail Firm(20)=(30)
(21)

E

E'

O

(31)

21

4.3.3 A Case where consumers cannot choose a supplier(Case (3) of Figure 1)
In the competitive markets, consumers can choose freely to purchase goods and services. A
consumer chooses a car among various cars produced by many different companies in a competitivemarket, leading to their free-choice among eco-friendly cars. However, something is different in theelectricity market in Japan. As already mentioned in Chapter 2, it is far from the competitive market
due to a number of reasons in Japanese electricity market. Among them, one is a regional monopoly
such as TEPCO to eliminate competition, and the other is the market system that makes consumers’
choice among power resources impossible. On the contrary, the case (3) in figure 1 implies a‘free-to-choose” model.
Section 4.3.1, using (6), has discussed the condition where the solar power is purchased. As in
4.3.1, the condition is the same as in 4.3.2 where the green electricity program and the FIT are
introduced. Actually, no demand for the solar power firm arises unless the numerator of (16),, becomes positive. Therefore, the key variables are
Whenbecomes bigger, and when the difference between

and

and

.

becomes smaller, thedemand share for the solar power firm becomes larger. As (25) shows, the subsidy to the solar power
firm, s, makes the difference smaller. Because c is the marginal cost to install an additional solar
panel of 1MW, increasing s makes c smaller. In this relation, it is notable that thanks to the
combination of the subsidy to be paid for residents who install solar panels, and of the voluntarymeasure under which the electric power companies purchase surplus energy that the residential
customer who install solar panels do not use themselves, Japan had ranked No.1 in the world for thephotovoltaic power generating capacity through 1994. The self-consumption system to use solar
panels supported by the subsidy is a kind of the combination of green electricity program and thesubsidy. However, after suspending the subsidy, Japan lost the rank, and Germany has ranked at the22No.1 for the installing capacity since 2005. Under the background, Japan has started again thesubsidy since FY2009.

4.4 Welfare Analysis
4.4.1 Framework
This section examines the welfare aspects of the electricity market focusing on the different
market structure shown in Figure 1. In particular, the economic as well as the social surplus in theframework of 4.3.1 and 4.3.2.1 are investigated. The consumer surplus (CS) in 4.3.1 is defined as(37).

On the other hand, the consumer surplus in 4.3.2.1 is defined as(38).

The producer surplus (PS) in 4.3.1 is defined as the sum of solar power firm’s surplus, PS11 and thethermal power firm’s surplus PS12. That is(39).

In 4.3.2.1, the producer surplus is defined as the sum of solar power firm’s surplus, PS21 and theretail firm’s surplus PS22. That is(40).

A social aspect of the welfare has been investigated by many authors (Lonbardini-Riipinen (2005),
Toshimitsu (2010) and Lambertini and Tampieri (2011)). Here the environmental burden in 4.3.1 issimply assumed as the excess emission of CO2 from generating electricity:
(41)

where

denotes the environmental burden when both firms do not make any efforts on theenvironment.

In 4.3.2.1, the environmental burden is assumed as(42)

The subsidy for the solar power firm by the governments is given by (43) in 4.3.1 and (44) in 4.3.2.1,

23respectively;
(43)

,

(44)

.

From (37), (39), (41) and (43), the total surplus in 4.3.1 is given by(45).

From (38), (40), (42), and (44), the total surplus in 4.3.2.1 is given by(46).

4.4.2 A Comparison of the Surplus
The consumer surpluses in 4.3.1 and in 4.3.2.1 are identical, because we confirmed in 4.3 thatthe value of p1 in 4.3.1 and in 4.3.2 is identical, and p2 = , and θ*=θ**. Thus, the surplus ofconsumers who are supplied electricity directly from the solar power firm is computed as
(47)
.
where

. The surplus of consumers whoare supplied from the thermal power firm in 4.3.1 and the retail firm in 4.3.21 are computed as
.
where

.

The producer surpluses of the solar power firm in 4.3.1(PS11) and 4.3.2.1 (PS21) are computed as.
Comparing (49) and (50) together, it is clear that the latter is larger by.

On the other hand, the producer surpluses of the thermal power firm (PS12) and the solar power firm
(PS22) are calculated as
,

24

.

Comparing (51) and (52) together, it is found that the latter is smaller by.

Moreover, the environmental burden in (41) is larger than in (42), the difference between them being
equal to. The governmental spending for the solar power firm in (44) isclearly larger than in (43) and the difference is.

Summarizing the above leads to the difference of the social welfare in 4.3.1 and .4.3.2.1 iscalculated as.

Therefore, it is clear that the social welfare in the competitive market in 4.3.1 is larger than in themarket in 4.3.2.1 where the mixed electricity is supplied under the FIT scheme in a green programsystem.

5. Conclusions and Further Remarks
This paper discussed the restructuring and development pattern of the structure of electricity
market in Japan mainly from theoretical perspectives. One of the main issues is the possibility of thefree choice of consumers between the electricity suppliers who generate electricity with different
power sources. An important finding of the paper is that the social welfare in the case (2) in figure 1
where the FIT is enforced is lower than in case (3) of the competitive market, meaning that the social
welfare is not enhanced as long as the mixed electricity is supplied. The other is that the demand for
direct purchase of the solar power depends on the marginal willingness to pay for the environment,
marginal utility of social-related evaluation, and the difference of prices between the solar powerfirm and the thermal power firm in the case (3) in figure 1, or the difference of prices between thesolar power and the retail firm in the case (2). If the numerator of (6) and (16) is not positive, the25demand for the direct purchase from the solar power firm does not arise.
The above mentioned findings are showing us the valuable implications to consider current
discussion about the future energy policy in Japan. The most controversial issue is the share of
power sources to which Japan should reach until 2030. The government conducted the public
hearings on the generation mix across the nation, in order to set the new energy policy. However, if
the share is determined from the political viewpoints, some opinions are neither reflected nor
estimated. Some policies, such as the FIT and the subsidy which we investigated here, may beneeded in order to reach the target. If the FIT which oblige some consumers to purchase the mixed
power continuously is enforced, we will not be able to choose the optimal use of power sources11.
Thus, any policy measures to increase the share of the renewable power source in the total should be
supported by consumers’ environmentally oriented behaviour. To support those policies, information
disclosure on power sources is needed for the green consumers. This is because the optimal
distribution of power sources cannot be attained without the market system in which consumers’
preference, that is their marginal willingness to pay for the environmental attributes, is properly
revealed.
Finally, we should address our future works. In this paper, we studied the electricity market using
the vertical differentiation model under the assumption of full coverage, because electricity is one ofessential goods. However, if total energy services are available in the future, the electricity does nothave to cover 100% of energy needs, and the assumption of full market coverage could be relaxed.
We would extend our research for those directions.

11

The policy paper announced by the Energy and Environment Council on 14 September, 2012 indicates that theshare of each power source should be determined as a result of the competition basis among power firms and theconsumers’ free choice. On the other hand, the paper also sets the numerical goal to triple the output of electricity
generated from renewable energy sources from 110 billion kilowatt-hours in 2010 to 300 billion kWh by 2030. To
reach the target, the paper envisages that FIT will be one of important policy measures. At any rate, it seems
impossible that consequences of the free competition are compatible with the outcome of the regulatory policy. Thus,
a considerable discrepancy may exist in the report (See, The Energy and Environment Council HP).

26

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