From: rosalee.fleming@enron.com
To: steven.kean@enron.com
Date: 2001-04-26 16:00:00+00:00
Subject: On Market Power in California

Ken wanted you to have a copy
---------------------- Forwarded by Rosalee Fleming/Corp/Enron on 04/26/2001 
03:51 PM ---------------------------


Willliam Hogan <William_Hogan@harvard.edu> on 04/25/2001 06:34:08 AM
To: ER:;
cc:  
Subject: On Market Power in California


FYI.? The complete version of the following paper is available on my web page 
at:

www.whogan.com



????????ON THE EXERCISE OF MARKET POWER THROUGH
STRATEGIC WITHHOLDING IN CALIFORNIA
Scott Harvey and William W. Hogan
April 24, 2001

EXECUTIVE SUMMARY

Beginning in June of 2000, the shock of unexpectedly high prices in the 
California electricity market convinced everyone of the need for policies to 
correct the apparent market failures.? The public debate and policy 
discussions have been dominated by a focus on market power as a principal 
problem amenable to regulatory solution.? However, design of effective 
policies to moderate prices or mitigate their effects depends on the 
diagnosis of the underlying causes.? High prices attributable largely to an 
exercise of market power in electric generation would point to particular 
market participants and behaviors that could be targeted for regulatory 
action.? By contrast, high prices attributable to bad electricity market 
design would indicate a need for changes in the design.? High prices 
attributable to higher fuel prices, environmental constraints and capacity 
shortages, on the other hand, would prompt actions to address the cost of 
fuel and environmental limitations and indicate that retail loads should 
receive the appropriate price signal for conservation.

Suppliers could affect market prices by strategically withholding some 
capacity in order to profit on the capacity actually sold in the market.? But 
charging high prices during periods of scarcity is not classified as 
exercising market power if there is no strategic withholding of supply.? 
Likewise, refusing to supply without being paid is not an exercise of market 
power.? Although the potential for withholding exists for many suppliers, the 
focus of attention has been on the exercise of market power by thermal 
generators in California.

On its face, the experience of extremely high prices suggests that the 
exercise of market power could be important.? But at the same time the data 
show that there have been profound changes in the California market such that 
the thermal generators have actually increased their production more than 
demand has grown.? If anything, thermal generators that hit annual output 
limits produced too much rather than too little in the summer of 2000.? 
Furthermore, the widespread impacts of higher electricity prices throughout 
the western market, both on and off peak,? indicate that if the exercise of 
market power is important it is occurring to an extent and through channels 
unprecedented in this or other electricity markets.? In short, this is a 
complicated story, and there is ample room for further investigation of the 
data and diagnosis of causes.

Examination of the major analyses of the exercise of market power reveals 
that the estimated magnitude of the possible strategic withholding of 
electric generation is small enough to make it important to verify the 
simplifying assumptions.? If strategic withholding were large and pervasive, 
then the real details of the California electricity market could be ignored.? 
But it is by now apparent that the evidence is not clear, and any finding of 
the presence or absence of strategic withholding of generation in the 
California electricity market could turn on the simplifying assumptions used 
in the analysis of the data.? For example, annual limits on production 
dictate that plants should not run in many hours when prices are higher than 
direct incremental costs; hence, examinations of output decisions for 
individual hours or months are necessarily incomplete.? The variation in real 
time conditions is large enough to produce significant reductions in output 
compared to the expectations given day-ahead prices; hence, with capacity 
constraints average optimal production is necessarily less than optimal 
production at average prices.? Limits on the ramping rate of generation 
units, start-up costs, minimum load costs and other operational 
inflexibilities imply that a dispatch day is not just twenty-four separate 
hours and must be analyzed chronologically, recognizing these factors.? And 
so on.? Accounting for such effects can reverse the implications of the 
previous evidence.? Unfortunately, the real details are neither simple nor 
incidental.

It is difficult to conduct a study of market power based solely on publicly 
available data.? A fuller analysis would require data available only to the 
California Independent System Operator, and has not been done.? Many factors 
contributed to higher electricity prices in California, and the market power 
theme is only, at most, part of the story.? The import of the previous 
analyses is not to prove that market power has been exercised in the 
California electricity market but, rather, to suggest that it might be 
important.? The import of the sensitivity analysis here is not to prove that 
market power has not been exercised in the electricity market? but, rather, 
to suggest that it is unlikely to be the dominant factor and may not even be 
significant.? With the available data in the public domain, and the special 
complications introduced by the California market design, the margin of error 
in estimating the extent of the possible exercise of market power through 
strategic withholding of electric generation is of the same order of 
magnitude as the effect being measured.? On balance, to date the publicly 
available data provides no reason for the Federal Energy Regulatory 
Commission to change its conclusion that there is no evidence of strategic 
withholding nor any proof that no strategic withholding has occurred.

By contrast, there is general agreement that the California electricity 
market design is &seriously flawed.8? Furthermore, there is evidence that the 
policy responses that have been adopted in California have accelerated an 
already serious market collapse.? Hence, without dismissing the possibility 
of the exercise of market power, the principal policy focus should be on 
fashioning workable solutions for the other more serious problems in market 
design that relate to the underlying causes of the market meltdown.

Separate from market power mitigation, California should pay its bills, raise 
incremental prices to retail customers, and move as quickly as possible to 
operating a coordinated and efficient market with consistent pricing for all 
that includes unit commitment, day-ahead scheduling, and real-time 
balancing.? Although not a panacea, these steps would address immediate 
problems and set the stage for longer-term initiatives to expand generation 
capacity, transmission infrastructure, and the reach of an efficient market 
to the western interconnected grid.






William W. Hogan
John F. Kennedy School of Government
Harvard University
79 John F. Kennedy Street
Cambridge, MA 02138
617-495-1317 (o)
617-495-1635 (f)
william_hogan@harvard.edu
web page: www.whogan.com
or
http://ksgwww.harvard.edu/people/whogan