Lessons for the New Zealand Electricity Supply Industry
Frank A. Wolak
Director, Program on Energy and Sustainable Development
Professor, Department of Economics
Stanford University
Stanford, CA 94305-6072 wolak@zia.stanford.edu
http://www.stanford.edu/~wolak
1

• Sentiment has been expressed that New Zealand may not able to afford expense of competition law regulator
– “Light-handed regulation” is a uniquely New Zealand concept
– Instead rely on self-policing actions of market participants, not mandates or enforcement actions of regulator
"The unfortunate truth may simply be that competition law is a luxury that some governments can no longer afford.“
Grant David (Telecom's lawyer): http://www.chapmantripp.com/news/Pages/Do-we-still-need-a-Commerce-
Commission.aspx
2

• Explain why New Zealand cannot afford do without a best-practice regulator for electricity sector
– Regulate price and terms of service for monopoly segments of industry
– Monitor industry and regulate rules for segments where market mechanisms are used to set prices
• Why effective regulatory oversight is essential to achieving a restructured electricity supply industry that benefits consumers
– Why challenge in New Zealand is particularly great
• Describe features of best-practice regulatory process that could be implemented in New Zealand
3

• What is Electricity Industry Re-structuring?
– Alternative solution to traditional market design problem for electricity supply
• Market Design Problem
– Generic market design problem
– Necessity of explicit market design process in electricity industry
• Two major dimensions of regulatory oversight
– Regulating monopoly segments of industry
– Regulating rules governing market-based segments of industry
• Goal of market design process in wholesale market regime
• Challenges that make achieving success in New Zealand even more difficult
– Vertical Integration
– Hydro-dominated system
– Transmission network configuration
• Best Practice Features for New Zealand Regulatory Process
– Price regulation for monopoly segment to enhance competition in market segments
– Market monitoring and rules regulation to enhance competition in market segments
4

• Replace explicit regulation with market mechanisms to set prices for some, but not all, industry segments
– Price-regulated open access to
• Transmission network
• Local distribution network
• Market mechanism to set prices for wholesale power and determine which generation units produce energy
• Market mechanism to set prices for retail electricity and determine which retailers sell electricity to final consumers
5

• Technology/economics of delivering electricity implies
– Only one transmission and distribution grid for a given geographic area
• Large fixed cost to construct network
• Close to zero marginal cost to operate
• In all regimes, monopoly supplier of transmission and distribution services for each geographic area requires strict regulatory oversight of prices
– Unregulated monopoly can set prices for use of network that extracts all monopoly profits from electricity supply
• How these segments are regulated can have large impact on benefits consumers receive from restructuring
6

• How can restructured regime yield benefits to consumers relative to vertically-integrated regulated monopoly regime?
– Need theory of market design to start to answer this question
• Market Design
– Set number and size of market participants
– Set rules for determining revenues each entity receives
– So that combined actions of each participant acting in its own best interest yields market outcomes as close as possible to market designer’s desired outcome
• Many feasible market designs, each of which can yield different market outcomes
– Vertically-integrated regulated utility most common historically
7

• Major challenge of market design process
– Once market rules are put in place all market participants will optimize against them
• Generation unit owners, transmission network owners, distribution network owners, retailers
– Market participants will push envelope of market rules
• Must analyze strategic implications of all market rules
– Anticipate how participants will use market rules to maximize their expected profits
• Exploit private information they possess
– Use principal-agent theory to understand strategic implications
8

• Examples—client/lawyer, patient/doctor, firm owner/firm manager, and regulator/firm
– One familiar to everyone here—Parent/child
• Principal faces an asymmetric information problem
– Typically does not observe everything that agent does about its economic environment
– Principal’s payoff depends on agent’s actions
• Other factors impact principal’s payoff
– Agent’s payoff depends on its own actions, method used by principal to compensate agent, and other factors
• Principal designs mechanism for compensating agent based on observable variables that causes agent to take actions desired by principal
9

• Market Design involves Principal/Agent problems at multiple levels
• First level—Regulator/Firm
– Principal = Market Designer
• Usually government and/or regulator
– Agents = Firms and consumers in market
• Second level—Firm Owner/Firm Manager
– Principal = Owner of Firm
– Agent = Management of Firm
10

• Proposed objective function for market designer
– Lowest annual average retail price of electricity consistent with long-term financial viability of industry
– In economist’s language--maximize consumer surplus subject to marginal firm in industry earning zero economic profit
• Both vertically-integrated and wholesale market regimes have access to same technology
• Differences in outcomes is explained by market participants facing different incentives about how to use it
11

• Most markets do not require explicit market design process
– Locations where economic agents trade
• Formation of New York Stock Exchange (NYSE)
• Evolution of retail coffee beverage market
• Economic agents are free to trade at any market they like
– Buyers search for markets offering lowest selling price
– Sellers search for markets that offer highest buying price
• Why do network industries, particularly electricity, require explicit market design process?
12

• Physical network required to deliver electricity
– Despite Nikola Tesla’s attempts, cannot beam electricity to final customers
– Consumers and producers cannot switch physical networks to buy from or sell from to find one they like best
– Economics and politics implies a single transmission and distribution network for single geographic area
• This requires designing a regulatory mechanism for planning, building, and operating network
– To ensure equal access to networks for all market participant
– To compensate entities that manages transmission and distribution networks
– To set prices charged for use of transmission and distribution networks
13

14

• Electricity supply industry extremely susceptible to the exercise of market power in the spot market
– Demand must equal supply at every instance of time at every location in the transmission network
– All electricity must be delivered through transmission network
– Non-storability of product
• Demand varies throughout the day
– Production subject to severe capacity constraints
– How electricity is priced to final consumers makes real-time demand elasticity effectively equal to zero
• Implication--Firms can exercise enormous amounts of market power in a very short period of time
15

• How to cause producers to supply electricity in technically and allocatively efficient manner
– Technically efficiency = produce the maximum amount of output for a given quantity of inputs—capital, labor, input energy, and materials
– Allocative efficiency = produce fixed amount of output at least cost given input prices
• Setting prices to recover incurred cost of production does not provide incentives for technically or allocatively efficient production
– Firm maximize expected profits subject to regulatory process used to set prices may not lead to least cost production
• Wolak (1994) “An Econometic Analysis of the Asymmetric Information, Regulator-
Utility Interaction,” available on web-site.
16

• Restructured regime restricts regulated portion of industry to smallest entity possible
– Transmission and distribution are only regulated services
– Generation and electricity retailing are open to competition
• Traditional regulated regime imposes regulatory process on all aspects of industry
– Final output price of vertically-integrated monopoly is regulated
• Choice between regulation and competition depends which regime comes closer to achieving market design goals for each stage of production process
– Choice between imperfectly competitive market versus imperfect regulatory process will depend on many region-specific factors
– For more on this issue see Wolak, F.A. “Regulating Competition in
Wholesale Electricity Supply,” on web-site.
17

– Firm usually knows its technological capabilities and the demand that it faces better than the regulator
– This leads to disputes between the firm and regulator over minimum cost mode to serve demand that firm faces
– Regulator can never know minimum cost of providing service
• Regulator can only know incurred costs of providing service
18

• Major problem with regulation (continued)
– There are laws against confiscating regulated firm’s assets
• Impossible to tell difference between regulator setting
– Output prices that confiscate firm’s assets
– Output prices that provide strong incentives for least-cost operation
– Long history of legal disputes in US that attempt to define process for setting prices that does not confiscate firm’s assets
– Firm understands value of superior information about its demand and technology in regulatory price-setting process
• Note: Effective regulatory process pushes this margin (making incurred cost = minimum cost) as hard possible, because consumers pay incurred costs
19

• Benefit of competition
– There are no laws against a firm’s competitors confiscating its assets through their output and pricing decisions
• Any firm unable to cover its costs at the price set by market must exit industry
• High cost firms exit the industry and are replaced by lower cost firms
– Contrary to regulated regime, no need to determine if a firm’s incurred production costs are the result of a least-cost mode of production
• If entry and exit barriers are low, then any firm that is able to remain in business must be producing at or close to minimum cost
– Possibility of exit from industry and ease of entry provides strong incentives for minimum cost production under market pricing
20

• Historical Benefits
– Economies to scale in generation of electricity
• Average cost of generation declines as total output increases
– Extensive transmission and distribution network necessary to deliver power
• More than one network raises average costs
– Economies of scale and scope from having generation, transmission, and distribution in same geographic monopoly
21

• Economies to scale and scope are less relevant than in early stages of industry
– Technological change in generation and transmission
– Economic growth has led to market demand that is large relative to efficient size of new generation plant
– Conclusion--modest or no economies of scale or scope over relevant range of output
• Strong incentive to provide diversity of products consumers demand
– Profitable niche markets
22

Price
P comp
> P reg
= A/Q d
MC
P
Competition
TR
Competition
= A + B TR
Regulation
= A
B
A
Q d
Quantity
23

If A < B, then competition allows consumers to pay less
If MC reg
> MC comp then competition implies lower costs
Price
TR
Competition
= A + C + D
TC
Competition
= C
TR
Regulation
= B + C + D
TC
Regulation
= B + C + D
MC
Regulated
B
MC
Competition P
Competition A
D
C
Q
Competition
Quantity
24

• When minimum cost of providing service is known, little reason to run a market for service
– Cost-of-service regulation can be used to set price
• When minimum cost of providing service is unknown, run a market to determine this cost
– Markets provide strong incentives for minimum cost production in both short-run and long-run
– Not necessarily strong incentives to pass-on lower costs in lower prices--market power problems
• Unless potential for significant cost reductions exist, introducing market pricing makes little sense
25

• Considerable uncertainty over minimum-cost method to serve electricity demand in both short-run and long-run
• Two sources of supply-side benefits of restructuring
– In short-run, lower variable cost operating of existing fleet of generation units
– In long-run, lower cost investments in mix of generation capacity needed to meet future demand
• Tremendous uncertainty over least-cost way to serve future demand particularly in a carbon-constrained world
• Important Lesson from US—Avoid market rules that eliminate incentive for firms to reduce costs
– Increases risk of that consumers pay market-clearing price based on incurred costs rather than minimum costs
• Few benefits to consumers realized from re-structuring
26

27

• To understand how to limit exercise of unilateral market power need to understand how firms exercise unilateral market power
– Limiting exercise unilateral market power will translate production cost reductions into lower wholesale prices
– Effective and transparent regulation of transmission and distribution network services will translate wholesale price reductions into lower retail prices
• Mechanisms for limiting the exercise of unilateral market power in short-term wholesale market
– Divestiture of generation units, Forward contracting,
Transmission network expansions, and Symmetric treatment of load and generation
28

• Q id
: Total market demand in load period i of day d
• SO id
(p): Amount of capacity bid by all other firms besides Firm
A into the market in load period i of day d as a function of market price p
• DR id
(p) = Q id
- SO id
(p): Residual demand faced by Firm A in load period i of day d, specifying the demand faced by Firm A as a function of the market price p
•  id
(p): Variable profits to Firm A at price p, in load period i of day d
• MC: Marginal cost of producing a MWH by Firm A
•  id
(p) = DR id
(p)(p – MC)
29

Price
Price
Q
D
SO(p)
DR(p)=Q
D
- SO(p)
Quantity
Quantity
30

31

32

33

Bid to Maximize Profits Subject to Residual Demand
34

• Profit-maximizing offer price above marginal cost if residual demand curve is downward sloping
• Residual Demand Curve unknown at time generator submits bids
– Demand uncertainty
– Uncertainty about actions of other suppliers
• Optimal bid curve depends on distribution of elasticities of residual demand function
35

Price
Bid to Maximize Expected Profits
P
1
P
2
S
Q
2
MR
2
Q
1
DR
2
MR
1
MC
DR
1
Quantity
36

37

38

• Make residual demand curve distribution perceived by all generation unit owners as flat as possible
– Generator facing flat residual demand curve distribution is unable to impact the market price with offer curves
– Optimal strategy for generation unit owner is to bid marginal cost curve (MC) as willingness to supply curve [S(p)]
– If this is true for all suppliers, market prices will be as close as possible to market designer’s optimum
39

• Divestiture of Generation Capacity
• Forward Financial commitments make firms bid more aggressively in short-term market
• Transmission upgrades to face all unit owners with more elastic residual demand curves
– Economic reliability of transmission network versus
Engineering reliability of transmission network
• Price Responsive Demand makes the residual demand curves perceived by all unit generation owners flatter
40

1
2
Price Price
DR
2
(p) = Q d
– SO
2
(p)
SO
1
(p) SO
2
(p) p max
DR
1
(p) = Q d
– SO
1
(p)
Q d
Quantity
DR
1
(p max
)
Quantity
41

Impact of Forward Contracts on Bidding Behavior
• QC id
: Contract quantity for load period i of day d for Firm A
• PC id
: Quantity-weighted average (over all hedge contract signed for that load period and day) contract price for load period i of day d
Price
2
P
M
P
C
1
P
M
Payments to Purchaser of Hedge
Contracts by Generators at
P
2
M
Payments to Generator by Purchaser of Hedge Contracts at
P
1
M
Q
C
Quantity
42

• Assume market clearing price p is determined by solving for the smallest price such that the equation SA id
(p) = DR id
(p) holds.
• The magnitudes QC id and PC day-ahead bidding process id are set far in advance of the actual
• Generators sign hedge contracts with electricity suppliers or large consumers for a pattern of prices throughout the day, week, or month, for an entire or fiscal year
• Variable profits (profits excluding fixed costs) to Firm A for load period i during the day d at price p as:
–  id
(p) = DR id
(p)( p - MC) - (p - PC id
)QC id
• This can be re-written as:
– 
(p) = (DR(p) - QC )(p - MC) + (PC - MC)QC = DR
C
(p)(p – MC) + F
• Note that second part of expression is fixed from a day-ahead perspective.
43

For same residual demand curve, DR(p), a supplier with a fixed-price forward contract obligation finds it profit-maximizing to produce more output and set a lower market price
44

C
C
C
C
S
NC
(p)
P H
NContract
DR High (p) - Q
C
P L
NContract
P H
Contract
P L
Contract
DR Low (p) - Q c
Q L
NContract
Q H
NContract
Q L
Contract
DR Low (p)
Q H
Contract
S
C
(p)
DR High (p)
45

• In vertically-integrated regime, single firm owns transmission network and all generation units needed to meet demand in firm’s service area
– Network built to meet engineering reliability standards
• In wholesale market regime, transmission network operation and expansion decisions are separate from generation ownership and operation decisions
– Network should be built to economic reliability standards
• Transmission network facilitates competitiveness of wholesale market
– Transmission network configuration determines how many independent suppliers are able to compete to supply energy at each location in wholesale market
46

• Enough transmission capacity so that
– Demand at all locations in network can be met with prespecified probability
– Assuming that virtually all generation units in network are owned and operated by same entity
• Because of structure of regulatory process in former regime, strong incentive for vertically integrated (VI) firm to operate its generation units to limit congestion
– VI utility interested in minimizing total cost of supplying all of retail load
– No incentive to operate high cost units more intensively to increase locational price differences
• This only increases total costs of VI utility which reduces its profits
• Recall VI utility’s revenue stream is independent of its actions
47

• Sufficient transmission capacity so that all locations in the network face significant competition from enough independent suppliers to cause them to bid close to their marginal cost curve the vast majority of hours of the year
– All suppliers face sufficiently flat residual demand curves a large fraction of hours of the year
– Expanding size of geographic market can only increase extent of competition that suppliers face if there is adequate transmission capacity to allow that to occur
• Generation divestiture decisions can increase the economic reliability of a given transmission network
– Conversely, to the extent that significant generation divestiture cannot be implemented, more transmission investment may be needed to achieve economic reliability
• Transmission network facilitates commerce in same way that inter-state highway system facilitates commerce US economy
– See Wolak (2011) “Measuring the Competitiveness Benefits of a Transmission
Investment Policy: The Case of the Alberta Electricity Market” on web-site
48

• Symmetric treatment of producers and consumers of electricity
– From perspective of grid reliability, a consumer is a supplier of “negawatts”--SN(p) = D(0) - D(p)
• Default price for all consumers should be hourly wholesale price
– Consumer is not required to pay this price for any of its consumption, just as generator is not required to sell any output at spot price
– To receive fixed price, consumer must sign a hedging arrangement with load-serving entity or electricity supplier
• There is nothing unusual about hedging spot price risk
– Health, automobile and home insurance, cellular telephone
49

Price
Price
Q (p)
D
Q
D
SO(p)
DR(p)=Q (p)-SO(p)
D
DR(p)=Q
D
- SO(p)
Quantity
Price-responsive aggregate demand flattens residual demand distribution faced by all suppliers
Quantity
50

• Active participation of final demand in wholesale market requires interval metering
• Without interval metering can only sell electricity based on monthly average price
– Conventional meters only measure total monthly consumption of electricity
• Read meter at beginning of month and end of month, monthly consumption is difference between two meter reads
• Firms have limited idea who in a given customer class is more expensive to serve in terms of wholesale energy costs
• With interval meters prices can differ across all hours of the month (hours of the day)*(Days of the Month),
– p(h,d) = price for hour h of day d
– Up to 744 prices per month
51

• Cost is not a barrier to ubiquitous interval metering

In US, cost savings on manual meter reading comes very close to paying for cost of interval metering technology
• Price of metering technology falling rapidly
• Sophistication of metering technology rising rapidly
• Virtually all households have Internet access and can receive price signals on real-time basis
• Regulator can coordinate a competitive procurement process for provision of interval metering infrastructure to regulated distribution companies
 Purchase cheapest meters that record hourly consumption
52

53

• Four largest suppliers in New Zealand are vertically integrated into retailing
• Firms are called “gentailers”
• Vertical integration between electricity generation and retailing effectively eliminates beneficial incentive of fixed-price forward market obligations on supplier behavior
• A fixed-price forward contract between retailer and supplier within in same firm has no impact of supplier’s offer behavior
• Supplier agrees to sell QC at PC to retailing affiliate
• Retailer agrees to buy QC at PC from generation affiliate
• No net impact of behavior of vertically-integrated firm because sale and purchase nets to zero within firm
• Gentailer still has same incentive to exercise unilateral market power
54

• Suppliers have little incentive to develop liquid market for fixed-price forward contracts
• They own physical assets needed to serve retail customers local to their generation units
• Developing a liquid forward market for energy would help retailers that do not own generation units compete in their service territory
• With vertical integration, fixed-price retail market obligations with final consumers limits incentive of supplier to exercise unilateral market power, but only for duration of contract
• Suppliers recognize that higher wholesale now prices can provide rationale for raising retail prices in future
• Vertical separation of generation from retailing creates level playing field for retail competition
• Provides strong incentive for retailers and generation unit owners to enter into fixed-price forward contracts for energy
55

• Hydro-dominated system makes achieving competitive market outcomes during low water conditions is extremely difficult
• Hydro suppliers attempt to conserve water by submitting steeper offer curves
• Thermal suppliers perceive steeper residual demand curves and submit steeper offer curves
• Output prices rise because of steeper offer curves and hydro suppliers find that they sell “too much water” and further steepen their offer curves
• Thermal suppliers respond by submitting steeper offer curves and prices rise further
• This dynamic has operated in all bid-based hydro-dominated markets around the world—New Zealand, California,
Colombia, Spain
56

• If hydro suppliers have re-insured water shortfall risk with thermal suppliers, impact of this dynamic can be limited
• Suppose thermal suppliers sign contingent contract with hydro suppliers to provide more energy at a fixed-price if water level falls below some pre-specified value
• Thermal suppliers have no incentive to raise wholesale price in response to steeper offer curve of hydro suppliers because they must make up hydro energy shortfall at fixed price
• Contingent contract would involve up-front payment by hydro suppliers to thermal suppliers for insurance against energy shortfall
• Vertical separation between generation and retailing can increase attractiveness of reinsurance for hydro suppliers and electricity retailers
57

• When transmission congestion in New Zealand occurs there can be extremely large price differences across locations
• Provides strong incentive for gentailers to consolidate load to nodes near where it owns generation units
• Increases riskiness of entry by retailer that owns no generation
• Buying out of short-term market to serve retail consumers can be extremely risky because of potential for congestion
• Finding a long-term hedge for locational wholesale energy price is difficult because firm most able to provide it is incumbent gentailer
• Market with long-term financial transmission rights and longterm energy contracts more likely to develop with less vertical integration
58

59

60

• Major lessons from re-structuring processes around the world
– Decide which segments of industry will employ a regulatory process to set prices and apply best possible regulatory mechanism
• Transmission and distribution
– Decide which parts should use market mechanisms to set prices and apply best possible market mechanisms
• Generation and retailing
– Implement proactive market monitoring process to detect and correct defects in market rules
• Measures of ability and incentive of suppliers to exercise unilateral market power
• Measures of market performance relative to competitive benchmark
61

• Improving regulatory process
– Establish an explicit and publicly observable regulatory price-setting process for transmission and distribution services
– Regulated firms submit publicly disclosed annual reports on revenues and costs and assets and liabilities using international regulatory accounting standards
– Regulatory process for setting output price is public process were interested parties can participate and provide testimony to regulator
– Regulator can only rely on evidence presented in public process to arrive at regulated price
• Failure to do so can result in decision being overturned on legal review
62

• Regulatory process should
– Establish a rate base for regulated entities (RB)
• Sum of past prudently incurred investment costs less accumulated depreciation computed from publicly disclosed financial information
– Set risk-adjusted rate of return on capital (r)
– Determine prudency of investment decisions (only prudent investments are allowed cost recovery in output price)
– Set test year output level (Q)
• Estimate variable cost of test year output (VC(Q))
– Set regulated price as p = (r*RB + VC(Q))/Q
• Set single price for all customers of a given class
(residential, commercial, industrial) for transmission and distribution services for given distribution network area
63

• On retailing and generation market competitiveness
– Single distribution and single transmission price for a given customer class for a given distribution network increases transparency of retail prices to final consumer
– Only reason for differences in retail price offers to customers by retailers is wholesale energy costs because transmission and distribution charges to serve customer are the same for all retailers
– Potential to increase competitiveness of retail market outcomes
• Transparent transmission and distribution pricing will make it easier to measure competitiveness of retail market outcomes
• Implicit wholesale price = P(retail) – P(transmission) –
P(Distribution)
• Data collection for retailing segment of industry to compute average retail price which can then be used to assess competitiveness of retailing segment
64

• Symmetric treatment of load and generation for customers with interval meters
– Retailer must pay actual cost of serving customer with interval meter each half-hour of the day
• Establishing interval metering as a regulated distribution service in New Zealand seems cost effective
– Encourage development of dynamic pricing of retail consumers to increase competitiveness generation and retailing
• Dynamic pricing—Retail prices that vary with real-time system conditions
– Time-of-Use pricing simply sets higher price in certain hours of day regardless of real-time system conditions
• Ample evidence in US, Japan, Europe of significant demand reductions in response to dynamic pricing
– Wolak (2010) An Experimental Comparison of Critical Peak and Hourly
Pricing: The PowerCentsDC Program
– Ito (2013) Using Dynamic Electricity Pricing to Address Energy Crises:
Evidence from Randomized Field Experiments
(with Takanori Ida and Makoto Tanaka)
65

• Multi-settlement market makes active demand-side participation much more straightforward that current single settlement market
• Large consumers and retailers can purchase energy in day-ahead market and sell it back in real-time
– Avoids problem of selling something that consumer or large retailer does not own
• Real-time market price penalizes demanders that consume more than day-ahead purchase
– In single settlement market must come up with ad hoc rules to penalize over-consumption relative to
“purchased” amount
66

• Address equity issues associated with higher residential electricity prices
– All US states and most industrialized countries provide subsidized electricity to low income consumers
– California has CARE program which provides subsidized electricity to low income consumers
– Low income consumers can pay a large share of monthly budget on electricity
• Particularly acute for low income consumers on South Island
– An important role of regulatory process in the US is to protect those consumers that find it hard to protect themselves
• Higher income consumers should be able to take actions to reduce bill
– Switch suppliers, install technology to increase flexibility of their half-hourly demand
67

• Transmission expansions to reduce frequency and magnitude of congestion
– Limits geographic basis risk to new entrants to retail markets distant from their generation units or forward contract delivery points
– Transmission expansions increase number of half-hours per year each generation owner faces competition from all generation unit owners in New Zealand
• Makes distribution of residual demand curve a generation unit owner faces flatter, reducing its ability to exercise unilateral market power, which Increases the competitiveness of short-term market outcomes
• Transmission planning process that accounts for these consumer benefits will improve competitiveness of wholesale market outcomes
68

• Separating generation from retailing would certainly help, but there are other less extreme regulatory interventions
• Proactive market monitoring process for wholesale and retailing segments of industry that measures performance of these two markets can assist in design of appropriate interventions
– Andrew Philpott (University of Auckland) excellent work on computing competitive counterfactual wholesale market price
– Develop methodology to derive counterfactual competitive retail price
– Regulator adopts “official price benchmarks” and collects data necessary to compute them
• Improves regulatory credibility (experience from California)
– Comparing benchmarks to actual market outcomes can diagnose possible market design flaws and design interventions that improve market performance
69

• All wholesale electricity markets must adapt to changing technology, policy goals, and market participant behavior
• Proactive market monitoring process is key to adapting to changing circumstances
• All regulators must engage in critical selfassessment of market performance relative to competitive benchmark to ensure consumers benefit from electricity re-structuring
• Recall that process of finding optimal market design in other industries is not available for electricity
– Market monitoring process can point the way to “optimal market design,” but this is process of continual learning and implementation of knowledge
70

• New Zealand faces many difficult challenges in achieving a restructured market that benefits consumers
• Best practice regulatory process for monopoly segments and market monitoring and market rule making process can achieve this goal
– Recognize and embrace fact that managing unilateral market power is major challenge of wholesale market regime
• Regulate monopoly segments to enhance competitiveness of wholesale and retail segments
– Push on margin of making incurred cost equal minimum cost
– Transparent distribution and transmission pricing
– Active participation of final consumers in wholesale market
– Transmission planning process that accounts for competitiveness benefits of expansions
• Design market rules to limit adverse impact of vertical integration and hydro-dominate electricity supply
– Data collection and market performance measurement and monitoring crucial to this process
71

72

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• Several hydro-dominated Latin American Countries (LACs) have a long history with electricity supply industry re-structuring using a cost-based short-term market
– Chile has had a wholesale market since mid-1980s
• Almost 300% increase in capacity since 1990, all privately financed
– Argentina has had a wholesale market since early 1990s
– Brazil, Peru, Panama, and Guatemala also run cost-based markets
• Under a cost-based market, suppliers submit technical characteristics of their generation units to market operator
– Heat rates, variable operating and maintenance costs
• Market operator computes variable cost of generation units using input fuel prices and from this information computes opportunity cost of water, usually by solving a stochastic dynamic program
• Market operator dispatches units and sets market-clearing prices using these variable cost estimates
– Galetovic, Munoz, and Wolak (2013) summarizes dispatch and pricing process for Chilean market
– Wolak (2008) discusses the case of Brazil
74

• Experience of Chile is generally thought to be a success
– LACs focus on what is needed to attract new investment—active forward market
– Based on US experience, it is difficult to argue that bid-based short-term markets have benefited consumers
• Many opportunities for suppliers to exercise unilateral market power
• LAC cost-based market focuses on development of forward market for energy
– Short-term market used to clear imbalances relative to forward market positions
– No regulatory intervention in market for fixed-price forward contracts between generation unit owners and retailers
– However, because of cost-based short-term market, retailers have limited incentive to sign fixed-price forward contracts
75

• Mandated forward contracting levels for retailers enforced by regulator
– Specify minimum hedging requirements at various time horizons to delivery, for example
• 95% coverage 1-year in advance of delivery
• 90% coverage 2-years in advance of delivery
• 85% coverage 3-years in advance of delivery
• Contracting levels enforced by penalties set by retailers
• Specify cost-of-shortage in stochastic dynamic program used to compute opportunity cost of water
– Political pressure to set low cost of shortage, which sets low wholesale prices in a cost-based market
– Low cost of shortage makes shortage periods increasingly likely because it sets a low opportunity cost of water and more water being used
• Brazil, Chile and other cost-based markets have faced several shortage periods when firm load had to be curtailed
76

• Technology of production dictates single transmission network and distribution network for a single geographic area
– Regardless of market structure—vertical integration or wholesale market
• Regulation of prices transmission and distribution owners charge, operating behavior, and expansion network decisions needed under either regime
– In former regime it was done implicitly through the retail price
– In new regime it must be done explicitly
• Standard regulatory challenges remain in new regime
– Asymmetric information between firm and regulator about minimum cost mode of supply
– Determine prudency of investment and operating decisions
– Provide incentives for least cost production
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• New regime requires regulatory process to design wholesale market and monitor its performance
• Firms in all industry segments will attempt maximize profits subject to mechanism used for regulated segments of industry
– Regulator must recognize and account for fact that all market participants behave strategically
• Market design and market monitoring process can have an enormous impact on market outcomes
• Rather than set prices that are “just and reasonable”, regulator must now implement market rules that result in market prices that are “just and reasonable”
– Massively more complex task (economists can help)
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• “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages.”
The Wealth of Nations, Book I Chapter II
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