Ebook Regulation and the Leverage of Local Market Power in the California Electricity Market
The electricity sectors of many countries are undergoing a transition from either state-ownership or regulated franchise monopoly to an organization that is more market-oriented. Despite the general move to market-based pricing, regulators of electricity markets around the world continue to struggle with the problem of incentivizing generators whose output, due to their location in the grid, has no viable substitutes.
Such generators possess ‘local’ monopoly power, and in deregulated settings have frequently been able to extract significant rents from their advantageous locations within a power system. Since strategically located generators also simultaneously compete in broader regional markets, the actions taken to exploit local market power can also effect market outcomes over larger areas. Similarly, regulatory mechanisms intended to mitigate local market power can also effect competition far beyond the geographic scope of their control.
In California, a contract structure known as the reliability must-run (RMR) contract was developed to address the problem of local market power. However, the contract form that was in place during 1998 created serious incentive problems. The most common contract during this period, known as contract A, paid generators a portion of their sunk and fixed costs, in addition to their operating costs, for each unit of power produced.
The payment structure of the RMR contracts was such that must-run generators received these lucrative payments only if they were not already committed to producing power through the regional market process. These payments created a clear and often significant opportunity cost to participating in the regional market. In other words, a generator that competed aggressively in the regional market was unlikely to receive RMR contract revenues, which were often well above those that could be obtained from the resulting regional market prices.
In this paper, we examine the impact of these contract payments on the bidding behavior of market participants. We find that, during the months of June through September 1998, A type RMR contracts had the effect of raising overall supply bid prices from most producers, thereby leading to higher energy prices in the California regional market. In this sense, a regulatory mechanism, the RMR contract, promoted the leveraging of the local market power of certain producers onto the broader wholesale electricity market.
The case of RMR contracts in California is an example of the interaction of sequential markets for the same commodity, where market rules in one market impact prices in all markets. The California electricity market features an hourly day-ahead market, which is in effect a forward financial market, and an hourly real-time physical spot market in which supply and demand are continuously balanced. Because must-run contracts are invoked during the period between the close of the day-ahead market and the operation of the spot market, one might think that the bidding incentives provided by these contracts should not impact suppliers other markets. However, by impacting the dynamic interaction between the day-ahead forward market and the spot market, RMR contracts appear to have affected the prices in both the spot and forward markets.
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