In January 1998, the Spanish government liberalized the market for electricity generation and introduced a spot market for electricity. The basic design of this electricity spot market is similar to the previously deregulated UK market and even closer to the California electricity market that was deregulated at about the same time. It is well known that both deregulation experiments in the UK and California suffered from being susceptible to the exercise of substantial market power. Indeed, the lack of almost any elasticity of demand in electricity markets leads to extraordinarily large incentives to raise price relative to other markets. In the UK the issue of market power has already led to fundamental reforms and in California there have been widespread discussions on how to improve the system, for example, by introducing real time pricing on the user side.
There are essentially four separate economic activities in electricity markets: generation, transmission, distribution and retailing (often called supply). With electricity liberalization transmission and distribution remained regulated because they are considered natural monopoly elements of the electricity system. Transmission and distribution services are payed at fixed per unit access prices. Most of the deregulation experiences liberalized generation imediately while retailing liberalization was gradual. The introduction of the spot market directly linked the two potentially competite activities: generation and retailing (see figure 3). By and large generation firms must sell their production in the spot market and retail and distribution firms must buy electricity from the spot market at the equilibrium price. One of the greatest concerns of post-liberalization has been market power of generation companies in the spot markets.
The potential for market power, in the Spanish electricity market was considered a problem even before deregulation (see Kühn and Regibeau 1998, Arocena, Kühn and Regibeau 1999) since the two largest firms in the industry controlled about 75% of the generation (table 1 shows, that this legacy of concentration has remained essentially unchanged through 2001). Besides the potential for market power in generation, table 1 also shows a unique feature of the Spanish electricity industry: the high degree of vertical integration into retailing (and distribution). Most deregulation experiments in fairly concentrated markets as in the UK and California have imposed vertical separation between generation and retailing activities in the belief that these would create incentives for entry into the industry. It was not clear then how vertical integration may affect the exercise of market power in electricity spot markets.
Due to the high degree of vertical integration a high proportion of the payments made and received from the spot market are effectively pure transfers between retail and generation activities of the same companies. Does market power matter at all in such a setting? Does vertical integration increase or decrease the impact of concentration in generation? What would be the impact of entry into liberalized retail markets on spot market prices given the high degree of concentration in generation? Would vertical separation increase or decrease the efficiency in generation? Would it lead to substantial changes in the spot market price? All of these are important policy questions, especially in the face of repeated attempts to reorganize the Spanish electricity market.
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Market Power and Vertical Integration in the Spanish Electricity Market
