Measuring Market Inef ciencies in California s Restructured Wholesale Electricity Market

Transcription

1 Measuring Marke Inef ciencies in California s Resrucured Wholesale Elecriciy Marke By SEVERIN BORENSTEIN, JAMES B. BUSHNELL, AND FRANK A. WOLAK* We presen a mehod for decomposing wholesale elecriciy paymens ino producion coss, inframarginal compeiive rens, and paymens resuling from he exercise of marke power. Using daa from June 1998o Ocober 2000 in California, we nd signi can deparures from compeiive pricing during he high-demand summer monhs and near-compeiive pricing during he lower-demand monhs of he rs wo years. In summer 2000, wholesale elecriciy expendiures were $8.98 billion up from $2.04 billion in summer We nd ha 21 percen of his increase was due o producion coss, 20 percen o compeiive rens, and 59 percen o marke power. (JEL L1, L9) In he spring of 2000, he momenum behind a dramaic resrucuring of he elecriciy indusry appeared o be irresisible. There were four regions of he Unied Saes wih independen sysem operaors running spo markes for wholesale elecriciy California, PJM (major pars of Pennsylvania, New Jersey, Maryland, Delaware, Virginia, and he Disric of Columbia), New England, and New York. Several oher saes were underaking iniiaives o resrucure heir elecriciy secor along similar * Borensein: Haas School of Business, Universiy of California, Berkeley, CA 94720, Universiy of California Energy Insiue, and NBER ( borense@haas. berkeley.edu); Bushnell: Universiy of California Energy Insiue, 2539 Channing Way, Berkeley, CA ( bushnell@haas.berkeley.edu); Wolak: Deparmen of Economics, Sanford Universiy, Sanford, CA 94305, and NBER ( wolak@zia.sanford.edu). Borensein is a member of he Governing Board of he California Power Exchange. Bushnell was a member of he Power Exchange s Marke Monioring Commiee during He is currenly a member of he California Independen Sysem Operaor s Marke Surveillance Commiee, of which Wolak is he Chair. The views expressed in his paper do no necessarily re ec hose of any organizaion or commiee. For helpful discussions and commens, we hank Carl Blumsein, Roger Bohn, Peer Cramon, David Genesove, Rob Gramlich, Paul Joskow, Ed Kahn, Alvin Klevorick, Chrisopher Kniel, Parick McGuire, Caherine Wolfram, an anonymous referee, and paricipans in numerous seminars. Jun Ishii, Ma Lewis, Erin Mansur, Seve Puller, Celese Saravia, and Marshall Yan provided excellen research assisance. lines. Beginning in summer 2000, however, soaring wholesale elecriciy prices in California made inernaional news and hreaened he nancial sabiliy of he sae. The disrupions in California slowed, and hreaened o reverse, he movemen oward resrucured elecriciy markes in he Unied Saes and elsewhere. In he afermah of California s elecriciy crisis, policy makers debaed he correc lessons o ake from he sae s resrucuring as well as he proper regulaory response o he crisis. Many of he answers o he quesions being debaed depend upon a proper diagnosis of he problems ha disruped California s power secor during his period. Were soaring power coss he resul of marke fundamenals such as rising fuel prices, environmenal cos, and a scarciy of generaing capaciy? Or were power suppliers able o exercise signi can marke power? In his paper we esimae he exen o which each of hese facors inpu coss, scarciy, and marke power in uenced marke oucomes in he California power marke from 1998 hrough We analyze inpu and oupu prices, generaor variable coss, and acual producion quaniies o measure he degree o which California wholesale elecriciy prices exceeded compeiive levels. We also address he quesion of he ef ciency impacs of marke power in his marke. While marke power has been sudied and esimaed in many indusries, here has been 1376

2 VOL. 92 NO. 5 BORENSTEIN ET AL.: ELECTRICITY MARKET POWER For he purpose of his analysis, we de ne he summer o be June hrough Ocober of each year. lile aenion paid o ineremporal variaion in he abiliy o exercise marke power. For indusries in which he good is sorable, such ineremporal variaion is necessarily small, because invenories grealy reduce ineremporal supply variaion, and possibly, demand variaion. In markes for nonsorable goods, including elecriciy and mos services, his is no possible. The problem is exacerbaed in elecriciy because demand is very inelasic in he shor run, and supply becomes very inelasic as producion approaches he sysem-generaion capaciy. Recognizing he dynamics of marke power is likely o be imporan in boh deermining is causes and crafing remedies as par of he evolving public policy oward elecriciy resrucuring. Luckily, due o he hisory of regulaion in elecriciy markes, daa exis on he hourly oupu of all generaing unis and ransmission power ows. In addiion, informaion colleced on he echnical characerisics of each California generaing uni during he regulaed monopoly regime allows very accurae esimaion of generaing uni-level variable coss. We nd ha, due o rising inpu coss, even a perfecly compeiive California elecriciy marke would have seen wholesale elecriciy expendiures riple beween he summers of 1998 and Marke power, however, also played a very signi can role. In summer 1998, 25 percen of oal elecriciy expendiures could be aribued o marke power, a gure ha increased o 50 percen in summer The increased percenage margins due o marke power combined wih subsanial producion cos increases for marginal producers o creae a drasic rise in absolue margins and, hus, pushed he marke ino a crisis laer in he summer of In Secion I, we discuss he issues raised in esimaing marke power in elecriciy markes and he consequences of marke power. We presen an overview of California s elecriciy marke in Secion II. In Secion III, we describe he esimaion echnique in deail in he conex of he California marke, addressing each componen of he marke and oulining he assumpions made in implemening he analysis. We ry o ake a conservaive approach, inerpreing he daa in a way ha would be likely o undersae he degree of marke power exercised. In Secion IV, we presen esimaes of premia of acual prices over he compeiive levels. In Secion V, we aemp o parse changes in compeiive revenues beween changes in acual coss and changes ha re ec rens o inframarginal compeiive sellers. We conclude in Secion VI. I. Marke Power Analysis in he Elecriciy Indusry During mos of he 1990 s, regulaory evaluaion of shor-run horizonal marke power in elecriciy focused on concenraion measures, such as he Her ndahl-hirschman index. Unforunaely, such measures are a poor indicaor of he poenial for, or exisence of, marke power in he elecriciy indusry, because he indusry is characerized by highly variable price-inelasic demand, signi can shor-run capaciy consrains, and exremely cosly sorage. 2 I is easy o show ha in such circumsances, rms wih very small marke shares could sill exercise signi can marke power. We use daa colleced on he echnological characerisics of generaing unis locaed in California o consruc a compeiive marke counerfacual ha we compare o acual marke oucomes. This compeiive counerfacual models each rm as a price-aker ha would sell power from a given plan so long as he price i received was greaer han is incremenal cos of producion. Of course, he cos of selling a uni of elecriciy can be greaer han he simple producion coss if he rm has an opporuniy cos ha is greaer han is producion cos, such as he revenue he rm would ge from selling power or reserve capaciy in a differen locaion or marke. On he oher hand, a high price in an alernaive marke can re ec marke power in ha marke, resuling in he ransmial of high 2 See Borensein e al. (1999) for a more deailed discussion of he applicabiliy of concenraion measures o marke power analysis in elecriciy markes and ciaions o regulaory decisions ha have relied on concenraion indices.

3 1378THE AMERICAN ECONOMIC REVIEW DECEMBER 2002 prices across markes by he response of compeiive suppliers. We discuss hese alernaive opporuniies below and how we accoun for hem in our analysis. Thus far, we have discussed only siuaionsin which a rm unilaerally exercises marke power. Anirus law is mos ofen concerned wih collusive aemps o exercise marke power. Unforunaely, many of he aribues ha faciliae collusion are presen in elecriciy markes: In mos elecriciy markes, rms play repeaedly, ineracing on a daily basis, so here is opporuniy o develop suble communicaion and collusive sraegies. The payoff from cheaing on a collusive agreemen may be limied due o capaciy consrains on producion, hough for he same reason, he abiliy o punish defecors may be limied. Finally, he indusry has fairly sandardized producion faciliies, so homogeneous coss may make i easier for rms o aain aci or explici collusive oucomes. All ha said, we have no explored he quesion of aci or explici collusion among rms in he California marke as a poenial cause of prices in excess of compeiive levels. 3 Raher, in his paper we focus on he compeiiveness of marke oucomes. In focusing on marke oucomes, here are wo indicaors ha clearly disinguish marke power, and each leads o a disinc esimaion echnique. Firs, in a compeiive marke, a rm is unable o ake any acion, including oupu decisions or offer prices, ha signi canly affecs he price in a marke. This suggess a mehod of esimaion ha involves sudying he bidding and oupu supply decisions of each rm in he marke o deec successful aemps o affec prices. This is he general approach used by Wolak and Rober H. Parick (1997), Caherine D. Wolfram (1998), Roger Bohn e al. (1999), Bushnell and Wolak (1999), Wolak (2000), and Puller (2001). The second empirical approach is a he marke level, and his is he one ha we adop here. We examine wheher he marke as a whole is seing compeiive prices given he producion capabiliies of all players in he marke. As 3 See Seven L. Puller (2001) for an analysis of his issue. such, his approach is less vulnerable o he argumens of coincidence, bad luck, or ignorance ha may be direced a analysis of he acions of a speci c generaor. I is less informaive abou he speci c manifesaions of marke power, bu i is effecive for esimaing is scope and severiy, as well as idenifying how deparures from compeiive oucomes vary over ime. This is he general approach used in Wolfram (1999). A leas wo papers, Erin T. Mansur (2001) and Paul L. Joskow and Edward Kahn (2002), uilize boh of hese approaches. A poenial drawback of he marke-level approach is ha i capures all inef ciencies in he marke, some of which may no be due o marke power. If, for insance, low-cos generaors were sysemaically held ou of producion simply due o a fauly dispach algorihm, ha would impac he esimae of marke power. During he period we sudy, he California marke clearly sill had a number of design aws ha may have conribued o inef cien dispach and marke pricing. For he grea majoriy of hese, however, he aw would be benign if rms aced as pure price-akers, raher han exploiing hese design aws o affec he marke price. Furhermore, we nd ha, over subsanial periods of ime, prices did no signi canly differ from our esimaes of marginal cos, indicaing ha here were no sysemic inef ciencies raising prices in all periods. Sill, our esimaes mus be aken wih he cavea ha hey include failures o achieve compeiive marke prices for reasons oher han marke power, including bad judgmen and confusion on he par of some generaors or markemaking insiuions. The Consequences of Marke Power In analyzing he ef ciency consequences of marke power in elecriciy, one mus begin from he recogniion ha shor-run elecriciy demand currenly exhibis virually zero price elasiciy. Almos none of he cusomers in California, or anywhere else in he Unied Saes, are charged real-ime reail elecriciy prices ha vary hour-o-hour as wholesale prices do. Because he exen of marke power varies remendously on an hourly basis, he absence of

4 VOL. 92 NO. 5 BORENSTEIN ET AL.: ELECTRICITY MARKET POWER In California and elsewhere, ime-of-use raes are common for large users. These price schedules generally have prese peak, shoulder, and off-peak raes, which are changed only wice per year. They do no disinguish, for insance, a weekday afernoon wih exremely high wholesale prices from a more moderae weekday afernoon. Borensein (2001, 2002) argues ha ime-of-use raes are an exremely poor subsiue for real-ime elecriciy pricing and ha real-ime pricing would grealy miigae wholesale price volailiy. Parick and Wolak (1997) esimae he wihin-day price responsiveness of indusrial and commercial cusomers facing real-ime half-hourly energy prices in he England and Wales elecriciy marke. They argue ha an elecriciy marke would be much less suscepible o he exercise of marke power if even one-quarer of peak demand had he average level of price responsiveness ha hey esimae. 5 Even direc access consumers, who bough energy from some source oher han heir incumben uiliy, were insulaed from wholesale energy price ucuaions in he shor run by he CTC. This is because he sranded cos componen paid by all consumers was calculaed in a way ha moved inversely o he energy price: he higher he energy price, he lower he CTC paymen for ha hour. very-shor-run elasiciy is criical o undersanding is consequences. 4 In sudying California speci cally, one mus also consider ha, during he ransiion period, enduse consumers were insulaed from energy price ucuaions by he Compeiion Transiion Charge (CTC). The CTC was implemened along wih he resrucuring of he indusry in order o allow he incumben uiliies o recover heir sranded generaion coss. Due o he CTC, he vas majoriy of end-use consumers faced xed reail rae schedules during he ransiion period. 5 Thus, he CTC grealy lessened even he monhly elasiciy of nal consumer elecriciy demand. Due o he exreme shor-run inelasiciy of demand, marke power in elecriciy markes has lile effec on consumpion quaniy or shor-run allocaive ef ciency. As described below, however, generaing companies in California vary markedly in heir coss and generaion capaciy, so he exercise of marke power by one rm can lead o an inef cien reallocaion of producion among generaing rms: a rm exercising marke power will resric is oupu so ha is marginal cos is below price (and equal o is marginal revenue), while oher rms ha are price-aking will produce unis of oupu for which heir marginal cos is virually equal o price. Thus, here will be inef cien producion on a markewide basis as more expensive compeiive producion is subsiued for less expensive producion owned by rms wih marke power. This is he oucome Wolak and Parick (1997) described in he U.K. marke, where higher-cos combined-cycle gas urbine generaors owned by new enrans provide baseload power ha could be supplied more cheaply by coal- red plans ha were being wihheld by he wo larges rms. Joskow and Kahn (2002) nd evidence of wihholding by large rms in he California marke. In addiion, several recen analyses have demonsraed ha he exercise of marke power in an elecriciy nework can grealy increase he level of congesion on he nework. 6 This increased congesion impacs negaively boh he ef ciency and he reliabiliy of he sysem. Marke power can also lead rms o uilize heir hydroelecric resources in ways ha decrease overall economic ef ciency. 7 Lasly, elecriciy prices in uence long-erm decision-making in a way ha can seriously impac he economy and generaion invesmen. While i has been poined ou ha high prices should spur new invesmen and enry in elecriciy producion, hese invesmens may no be ef cien if moivaed by high prices ha are caused by marke power, which may indicae a need no for new capaciy, bu for he ef cien use of exising capaciy. Ari cially high prices also can lead some rms no o inves in producive enerprises ha require signi can use of elecriciy, or o inef cienly subsiue o less elecric-inensive producion echnologies. Beyond he ef ciency consideraions, marke power has poenially large and imporan redisribuionaleffecs. The California elecriciy crisis of illusraes boh he immense poenial size of hese effecs and he dif culy of analyzing hem. The ransiional reail rae freeze associaed wih he CTC mean ha he uiliies bore he brun of he wholesale price increases. The uiliies evenual response was o declare bankrupcy in one case, and hreaen o in anoher, so he raepayers or axpayers 6 See Judih B. Cardell e al. (1997), Bushnell (1999), Borensein e al. (2000), and Joskow and Jean Tirole (2000). 7 See Bushnell (2003).

5 1380 THE AMERICAN ECONOMIC REVIEW DECEMBER 2002 ulimaely became he bearers of much of hese coss. A his wriing, i is sill unclear who will bear wha share of he expense, and how much of he revenues paid o generaors will be refunded o buyers under orders from federal regulaors. II. The California Elecriciy Marke Through December 2000, he wo primary marke insiuionsin California were he Power Exchange (PX) and he Independen Sysem Operaor (ISO). The PX ran a day-ahead and day-of marke for elecrical energy uilizing a double-aucion forma. Firms submied boh demand and supply bids, hen he PX se he marke-clearing price and quaniy a he inersecion of he resuling aggregae supply and demand curves. In he PX day-ahead marke, which was by far he larges marke in California, rms bid ino he PX offers o supply or consume power he following day for any or all of he 24 hourly markes. The PX markes were effecively nancial, raher han physical; rms could change heir day-ahead PX posiions by purchasing or selling elecriciy in he ISO s real-ime elecriciy spo marke. 8 The PX was no he only means for buyers and sellers o ransac elecriciy in advance of he acual hour of supply. A buyer and seller could make a deal bilaerally. All insiuions ha scheduled ransacions in advance, including he PX, were known as scheduling coordinaors (SCs). 9 Because SCs use he ransmission grid o complee some ransacions, hey are required o submi he generaion and load schedules associaed wih hese ransacions o he ISO. The ISO is responsible for coordinaing he usage of he ransmission grid and ensuring ha he cumulaive ransacions, or schedules, do no consiue a reliabiliy risk, i.e., are no 8 Though he ransacion coss of rading in he PX and ISO differed, hese differences were negligible relaive o he coss of he underlying commodiy, elecrical energy. 9 In January of 2001, he PX ceased operaion and he California Deparmen of Waer Resources assumed responsibiliy for he bulk of wholesale purchases on behalf of all invesor-owned uiliies in California, negoiaing bilaeral purchases and operaing as is own SC. likely o overload he ransmission sysem. 10 As he insiuion responsible for he real-ime operaion of he elecric sysem, he ISO mus also ensure ha aggregae supply is coninuously mached wih aggregae demand. In doing so, he ISO operaes an imbalance energy marke, which is also commonly called he real-ime, or spo, energy marke. In his marke, addiional generaion is procured in he even of a supply shorfall, and generaors are relieved of heir obligaion o provide power in he even ha here is excess generaion being supplied o he grid. Like he PX, his marke is run hrough a double-aucionprocess, alhough of slighly differen forma. Firms ha deviae from heir formal schedules are required o purchase (or sell) he amoun of heir shorfall (or surplus) on he imbalance energy marke. During our sample period, no furher penalies were assessed for deviaing from an advance schedule. The imbalance energy marke herefore serves as he de faco spo marke for energy in California. During our sample period, he ISO imbalance energy marke consiued less han 5 percen of oal energy sales wih he PX accouning for abou 85 percen and he remainder aking place hrough bilaeral rades. The ISO also operaes markes for he acquisiion of reserve, or sand-by, capaciy. Reserve capaciy is used o mee unexpeced demand peaks and o adjus producion a differen poins on he grid in order o relieve congesion on he ransmission grid while sill meeing all demand. These reserves, known as ancillary services, are purchased hrough a series of aucions ha deermine a uniform price for he capaciy of each reserve purchased. Mos of he reserve capaciy is sill available o provide imbalance energy in real ime, and herefore will impac he spo price. A producion uni commied o provide reserve capaciy during an hour would herefore earn a capaciy paymen for being available and, if called upon in real ime, would earn he imbalance energy price for acually providing energy. Regulaion reserve, he mos shor-erm re- 10 Unlike he PX, he ISO coninued o funcion in approximaely is original role hrough he elecriciy crisis.

6 VOL. 92 NO. 5 BORENSTEIN ET AL.: ELECTRICITY MARKET POWER 1381 serve, is reaed differenly. Regulaion reserve unis are direcly conrolled by he ISO and adjused second-by-second in order o allow he ISO o coninuously balance supply and demand, and o avoid overloading of ransmission wires. For his reason, we rea i differenly in our analysis as described laer. A. Marke Srucure of California Generaion The California elecriciy generaion marke a rs glance appears relaively unconcenraed. The former dominan rms, Paci c Gas & Elecric (PG&E) and Souhern California Edison (SCE), divesed he bulk of heir fossil-fuel generaion capaciy in he rs half of 1998 and mos of he remainder in early Mos of he capaciy sill owned by hese uiliies afer he divesiures was covered by regulaory side agreemens, which prescribed he price he seller was credied for producion from hese plans independen of he PX or ISO marke prices. These divesiures lef he generaion asses in California more or less evenly disribued beween seven rms. The generaion capaciy of hese rms ha was locaed wihin he ISO sysem during July 1998 and July 1999 is lised in Table 1. Fossil includes all plans ha burn naural gas, oil, or coal o power he plan, bu over 99 percen of he oupu from hese plans is fueled by naural gas. The vas majoriy of capaciy lised as owned by oher rms was composed of small independen power projecs. The marke srucure during 2000 was largely unchanged from ha of As can be seen from Table 1, PG&E was he larges generaion company during he summer of The seemingly dominan posiion of PG&E is offse o a large exen by is oher regulaory agreemens. All of is nuclear generaion in California, for insance, is reaed under rae agreemens ha do no depend on marke prices. More imporanly, he incumben uiliies in California were he larges buyers of elecriciy during his ime period The uiliies had no incenive o raise marke prices because hey were ne buyers of elecriciy and he revenue from power ha hey sold ino he PX was jus need ou from heir power purchase coss. In fac, he CTC mechanism paid he hree invesor-owned uiliies he difference TABLE 1 CALIFORNIA ISO GENERATION COMPANIES (MW) July 1998 online capaciy Firm Fossil Hydro Nuclear Renewable AES 4, Duke 2, Dynegy 1, PG&E 4,004 3,878 2, Relian 3, SCE 0 1,164 1,720 0 SDG&E 1, Oher 6,617 5, ,267 July 1999 online capaciy Firm Fossil Hydro Nuclear Renewable AES 4, Duke 2, Dynegy 2, PG&E 580 3,878 2, Relian 3, SCE 0 1,164 1,720 0 Miran 3, Oher 6,617 5, ,888 Source: California Energy Commission ( B. Analyzing Marke Power in California s Elecriciy Marke Criical o sudying marke power in California is an undersanding of he economic ineracions beween he muliple elecriciy markes in he sae. Paricipans moved beween markes in order o ake advanage of higher (for sellers) or lower (for buyers) prices. For insance, if he ISO s real-ime imbalance energy price was consisenly higher han he PX dayahead price, hen sellers would reduce he amoun of power hey sell in he PX and sell more in he ISO imbalance energy marke. These aemps o arbirage he PX/ISO price difference would cause he PX price and ISO imbalance energy price o converge. For his reason, i is no useful o sudy he PX marke, or any oher of he California markes, in isolaion. The srong forces of nancial arbirage mean ha any change in one marke ha affecs beween xed wholesale price (implici in heir frozen reail rae) and he hourly wholesale price per uni of energy consumed in heir disribuion service erriory.

7 1382 THE AMERICAN ECONOMIC REVIEW DECEMBER 2002 ha marke price will spill over ino he oher markes. 12 This ineracion of he differen California elecriciy markes means ha we mus sudy he enire California energy marke in order o analyze marke power in he sae. For his reason, in he analysis below we look a all generaion in he ISO conrol area regardless of wheher he power from a generaing plan is being sold hrough he ISO, he PX, or some oher scheduling coordinaor. Recogniion ha he California power marke is effecively an inegraed marke due o arbirage forces yields wo oher imporan insighs. Firs, alhough he California marke has some large buyers of elecriciy direcly purchasing from he ransmission nework who may respond o hourly wholesale prices, he large uiliy disribuion companies (UDCs) canno conrol he level of end-use demand of heir cusomers because hese cusomer face price schedules ha do no vary wih he hourly wholesale price. The UDCs canno herefore reduce end-use consumpion in a given hour in order o lower overall power purchase coss. They did have some limied freedom as o which marke hey used for purchase of heir required power, choosing beween buying dayahead in he PX and spo purchases from he ISO imbalance energy marke. Noneheless, because sellers could move beween markes as well, ulimaely he buyers had no abiliy o exercise monopsony power, because hey could no reduce heir hourly demand for energy. The second insigh from a recogniion of marke inegraion involves he impac of price caps in he various markes. Because he ISO imbalance energy marke was he las in a sequence of markes, he level of he price cap in he imbalance energy marke fed back o form an implici cap on prices in he oher advance markes. Tha is, knowing ha he maximum one migh have o pay for power in real ime was capped a $250 per megawa-hour (MWh), for example, no buyer would be willing o pay more han $250 for purchases in advance. Thus, 12 Borensein e al. (2001) nds ha alhough signi can price differences beween he PX and ISO did occur during individual monhs, overall, here was no consisen paern of he PX price being higher or lower han he ISO price. he aggregae demand curve in he day-ahead PX marke became near horizonal a prices approaching he level of he price cap in he ISO imbalance energy marke. 13 Many of he suppliers ha compee in he ISO or PX also are eligible o earn capaciy paymens for providing ancillary services, as well as energy paymens for generaing in real ime, if hey bid successfully ino one of he ancillary services markes. Ancillary services herefore represen an alernaive use of much of he generaion capaciy in California. I is herefore necessary o consider he ineracion beween he energy and ancillary services markes. In he case of he California marke, he relevan consideraion is ha he provision of ancillary services in mos cases does no preclude he provision of energy in he real-ime marke. Thus, for he bulk of generaion, he decisions o sell ino ancillary service capaciy markes and real-ime energy markes are no muually exclusive. I is imporan o recognize ha he pool of suppliers available o ancillary services markes is very similar o ha available o he energy markes. The main difference is ha some generaors are physically unable o provide cerain ancillary services. Thus, here are fewer poenial suppliers for some ancillary services han here are for energy. We herefore would expec ha he energy marke would be a leas as compeiive as he ancillary services markes, and probably more so. In fac he ancillary services markes, for a variey of reasons, appear o have been signi canly less compeiive han he energy marke during he ime period of our sudy. 14 The oher prominen opporuniy for he usage of California generaion is he supply of power o neighboring regions. Higher prices for elecriciy ouside of California could produce a resul in which generaors wihin California were able o earn prices above heir marginal cos, even if all generaors behaved as priceakers. For his o be he case, however, he California ISO region would have o be a ne exporer of power. During our sample period, 13 See Bohn e al. (1999). 14 See Wolak e al. (1998).

8 VOL. 92 NO. 5 BORENSTEIN ET AL.: ELECTRICITY MARKET POWER 1383 such condiions arose in only 17 hours ou of he 22,681 hours in he sample. Even in hese hours, he maximum ne quaniy of energy expored ou of he ISO conrol area in any hour was a modes 608 MWh. Therefore, if we assume ha rading in hese markes was ef cien, he ne expor opporuniies for producers wihin California were very limied relaive o he California marke. Even if his were no he case, however, our analysis would fully accoun for he opporuniy cos of expors, because under he California marke srucure rms from oher saes had he opion o purchase power hrough markes run by he PX and ISO. Thus, power expored o Arizona, for example, would raise he quaniy demanded in he California marke, and herefore would increase he compeiive markeclearing price wihin he California PX and ISO markes. If ransmission became congesed, hen furher expors would be infeasible and he quaniy demanded in he California marke would include only he expors up o he ransmission consrain. Thus, he compeiive marke prices we esimae incorporae opporuniies for expor from California. III. Measuring Marke Power in California s Elecriciy Marke The fundamenal measure of marke power is he margin beween price and he marginal cos of he highes cos uni necessary o mee demand. As discussed above, if no rm were exercising marke power, hen all unis wih marginal cos below he marke price would be operaing. Even in a marke in which some rms exercise considerable marke power, he marginal uni ha is operaing could have a marginal cos ha is equal o he price. When a rm wih marke power reduces oupu from is plans or, equivalenly, raises is offer price for is oupu, is producion is usually replaced by oher, more expensive generaion ha may be owned by nonsraegic rms. In esimaing a price-cos margin in his paper, we herefore mus esimae wha he sysem marginal cos of serving a given level of demand would be if all rms were behaving as price-akers. In he following subsecions we describe he assumpions and daa used for generaing esimaes of he sysem marginal cos of supplying elecrical energy in California. A. Marke-Clearing Prices and Quaniies As described above, he California elecriciy marke in fac consiss of several parallel and overlapping markes. Given ha generaion and disribuion rms, as well as oher power raders, can arbirage he expeced price of energy across hese commodiy markes, we rely upon he unconsrained PX day-ahead energy price as our esimae of energy prices in any given hour. 15 We chose o rely upon he PX unconsrained price because he PX handled over 85 percen of he elecriciy ransacions during our sample period and he unconsrained PX price represens he marke condiions mos closely replicaed in our esimaes of marginal coss. In paricular, we do no consider he coss of ransmission congesion or local reliabiliy consrains in our esimaes of he marginal cos of serving a given demand. The PX unconsrained price is also derived by maching aggregae supply wih aggregae demand wihou considering hese consrains. The resuling markeclearing price herefore re ecs an oucome ha would occur in he absence of ransmission consrains, jus as our cos calculaions re ec he oucome in a marke in which all producers are price-akers and here are no ransmission consrains. 16 I has been argued ha he day-ahead PX price should be expeced o sysemaically oversae he marginal cos of energy supply because sellers in he day-ahead marke would include a 15 One migh be concerned ha his arbirage would no hold in ligh of he requiremen during our sample period ha he hree invesor-owned uiliies buy all of heir energy from he PX. Given he nancial naure of he PX marke and availabiliy of a number of forward marke producs o hedge he day-ahead PX price risk, he full meaning of his requiremen was ambiguous. More imporanly, Borensein e al. (2001) nd ha he PX and ISO prices rack quie closely hroughou mos of our sample period. 16 We would like o emphasize again ha we use he PX price as represenaive of he prices in all California elecriciy markes. This is no a sudy of he PX marke and he marke power we nd is no limied o he PX marke. I is he amoun we esimae o be presen in all California elecriciy markes. Quaniaively similar resuls obain using day-ahead or real-ime zonal prices.

9 1384 THE AMERICAN ECONOMIC REVIEW DECEMBER 2002 premium in heir offer prices o accoun for he opporuniy of earning ancillary services revenues, which require ha he unis no be commied o sell power in a forward marke. However, if his were rue, hen he PX price would also be sysemaically higher han he ISO real-ime price, which would no include such a premium because suppliers of ancillary services are also eligible o sell energy in he real-ime marke. Empirically his is no he case. Over our sample period, he PX average price was no signi canly greaer han he ISO average price. 17 The ineracion of hese energy markes also requires us o use he sysemwide aggregae demand as he marke-clearing quaniy upon which we base our marginal cos esimaes. This level herefore includes consumpion hrough he PX, oher SCs, and any imbalance energy demand ha is provided hrough he ISO imbalance energy marke. Consumpion from all of hese markes is in fac meered by he ISO, which in urn allocaes imbalance energy charges among SCs during an ex pos selemen process. We are herefore able o obain he aggregae quaniy of energy supplied each hour from he ISO selemen daa. The acquisiion of reserves by he ISO also requires discussion here. Since he ISO is effecively purchasing considerable exra capaciy for he provision of reserves, i migh seem appropriae o consider hese reserve quaniies as par of he marke-clearing demand level. However, wih he excepion of regulaion reserve, as described below, all oher reserves are normally available o mee real-ime energy needs if scheduled generaion is no suf cien o supply marke demand. 18 Thus, he real-ime energy price is sill se by he ineracion of real-ime energy demand including quaniies supplied by reserve capaciy and all of he generaors ha can provide real-ime supply. Therefore, we consider he real-ime energy demand in each hour o be he quaniy ha mus be supplied, and capaciy seleced for reserve services o be par of he capaciy ha can mee ha demand and, as such, o be par of our aggregae marginal cos curve. Unlike he oher forms of reserve, regulaion capaciy is, in a way, held ou of he imbalance energy marke and is capaciy could herefore be considered o be unavailable for addiional supply. For his reason we add he upward regulaion reserve requiremen o he markeclearing quaniy for he purposes of nding he overall marginal cos of supply. 19 B. Marginal Cos of Fossil-Fuel Generaing Unis To esimae he marginal cos of producion for an ef cien marke, we divide producion ino hree economic caegories: reservoir, musake, and fossil-fuel generaion. Reservoir generaion includes hydroelecric and geohermal producion. These faciliies differ from all ohers in ha hey face a binding ineremporal consrain on oal producion, which implies an opporuniy cos of producion ha generally 17 See Borensein e al. (2001). There is also a fundamenal heoreical aw in his argumen. Though opion value would cause a rm o offer power in he day-ahead marke a a price above is marginal cos, arbirage on he demand side (and by sellers ha do no qualify o provide ancillary services) would sill equalize he marke prices. The equilibrium oucome would jus have a reduced share of power sold hrough he day-ahead marke due o he forgone opion value. 18 In oher words, all reserve capaciy ha is economic a he marke price is assumed o be used o mee energy demands in real ime. Due o reliabiliy concerns, he ISO occasionally has no uilized some ypes of reserve ( spinning and nonspinning ) for he provision of imbalance energy even when he unis are economic (see Wolak e al., 1998). The condiions under which his occurs are somewha irregular and dif cul o predic. For he purposes of his analysis we have assumed ha hese forms of reserve are uilized for he provision of imbalance energy. 19 Regulaion reserve is procured for boh an upward (increasing) and downward (decreasing) range of capaciy. The amoun of upward regulaion reserve a imes reached as high as 10.8 percen of oal ISO demand, alhough he mean percenage of upward regulaion was 2.2 percen over our sample. Because he generaion unis ha are providing downward regulaion are, by de niion, producing energy, he capaciy providing downward regulaion should no be considered o be held ou of he energy marke. Noe also ha by adding regulaion needs o he marke demand, we are implicily assuming ha all regulaion requiremens are me by generaion unis wih coss below he markeclearing price. To he exen ha some unis providing regulaion would no be economic a he marke price, his assumpion will end o bias downward our esimae of he amoun of marke power exercised.

10 VOL. 92 NO. 5 BORENSTEIN ET AL.: ELECTRICITY MARKET POWER 1385 FIGURE 1. CALIFORNIA FOSSIL-FUEL PLANTS MARGINAL COST CURVES, SEPTEMBER exceeds he direc producion cos. Mus-ake generaion operaes under a regulaory side agreemen and is always inframarginalo he marke. Because of he incenives in he regulaory agreemens, hese unis will always operae when hey physically can. All nuclear faciliies are mus-ake, as well as all wind and solar elecriciy producion. We discuss below our reamen of reservoir and mus-ake generaion. For fossil-fuel generaion, we esimae marginal cos using he fuel coss and generaor ef ciency ( hea rae ) of each generaing uni, as well as he variable operaing and mainenance (O&M) cos of each uni. For unis under he jurisdicion of he Souh Coas Air Qualiy Managemen Disric (SCAQMD) in souhern California, we also include he cos of NOx emissions, which are regulaed under a radeable emissions permi sysem wihin SCAQMD. The cos of NOx permis was no signi can in 1998 and 1999, bu rose sharply during he summer of The generaor cos esimaes are deailed in Appendix A. Figure 1 illusraes he aggregae marginal cos curve for fossil-fuel generaion plans locaed in he ISO conrol area ha are no considered o be mus-ake generaion and shows how i increased beween 1998 and 2000 due o higher fuel and environmenal coss. 20 Noe ha because he higher-cos plans 20 Coss of generaion shown in Figure 1 are based on monhly average naural gas and emissions permi prices. Here and hroughou our analysis, we assume ha gas prices are compeiively deermined and accuraely repored. If gas markes were no compeiive or repored prices exceeded end o be he leas fuel ef cien and he heavies polluers, increases in fuel coss and polluion permis no only shif he supply curve, bu also increase is slope since he coss of highcos plans increase by more han he coss of low-cos plans. 21 The supply curves illusraed in Figure 1 do no include any adjusmens for forced ouages. Generaion uni forced (as opposed o scheduled) ouages have radiionally been reaed as random, independen evens ha, a any given momen, may occur according o a probabiliy speci ed by ha uni s forced ouage facor. In our analysis, each generaion uni, i, is assigned a consan marginal cos mc i re ecing ha uni s average hea rae, fuel price, and is variable O&M cos as well as a maximum oupu capaciy, cap i. Each uni also has a forced ouage facor, fof i, which represens he probabiliy of an unplanned ouage in any given hour. Because he aggregae marginal cos curve is convex, esimaing aggregae marginal cos using he expeced capaciy of each uni, cap i z (1 2 fof i ), would undersae he acual expeced cos a any given oupu level. 22 We herefore simulae he marginal cos curve ha accouns for forced ouages using Mone Carlo simulaion mehods. If he generaion unis i 5 1,..., N are ordered according o increasing marginal cos, he aggregae marginal cos curve produced by he jh draw of his simulaion, C j (q), is he marginal cos of he kh cheapes generaing uni, where k is deermined by (1) k 5 arg min5 O q6 x x I~i! z cap i $. i 5 1 he acual prices paid by elecriciy generaors, as recen Federal Energy Regulaory Commission ndings have suggesed, hen we have underesimaed he full impac of marke power on he wholesale price of elecriciy. 21 Our esimaes assume ha he raed capaciies of he plans, cap i, are sricly binding consrains. I has been poined ou o us ha he plans can be run above raed capaciy, bu a he cos of increased wear and more frequen mainenance. If we incorporaed his facor abou which here seems o be very lile deailed informaion i would shif righward he indusry supply curve and would increase our esimaes of he exen o which marke power was exercised. 22 For any convex funcion C(q), of a random variable q, we have, by Jensen s inequaliy, E(C(q)) $ C(E(q)).

11 1386 THE AMERICAN ECONOMIC REVIEW DECEMBER 2002 where I(i) is an indicaor variable ha akes he value of 1 wih probabiliy of 1 2 fof i,and0 oherwise. For each hour, he Mone Carlo simulaion of each uni s ouage probabiliy is repeaed 100 imes. In oher words, for each ieraion, he availabiliy of each uni is based upon a random draw ha is performed independenly for each uni according o ha uni s forced ouage facor. The marginal cos a a given quaniy for ha ieraion is hen he marginal cos of he las available uni necessary o mee ha quaniy given he unavailabiliy of hose unis ha have randomly suffered forced ouages in ha ieraion of he simulaion. If, during a given ieraion, he fossil-fuel demand (oal demand minus hydro, mus-ake, and he supply of impors a he price cap) exceeded available capaciy, he price was se o he maximum allowed under he ISO imbalance energy price cap during ha period. Noe ha in nearly all cases, he PX price in ha hour did no hi he price cap, so such oucomes were couned as negaive marke power oucomes in he analysis. Thus, hese oucomes are no driving, and if anyhing are reducing, our nding of marke power. We did no adjus he oupu of generaion unis for acual ouages, because he scheduling and duraion of planned ouages for mainenance and oher aciviies is iself a sraegic decision. Wolak and Parick (1997) presen evidence ha he iming of such ouages was exremely pro able for cerain rms in he U.K. elecriciy marke. I would herefore be inappropriae o rea such decisions as random evens. Because we nd marke power in he summer monhs high-demand periods in California in which he uiliies have hisorically avoided scheduled mainenance on mos generaion i is unlikely ha scheduled mainenance could explain hese resuls in any case. 23 We would expec scheduled mainenance o ake place in he auumn, winer, and spring monhs, which is he ime period over which we nd lile, if any, marke power. The operaion of generaion unis enails 23 Scheduled mainenance on mus-ake resources and reservoir energy sources was accouned for under he procedures oulined in he following subsecions. oher coss in addiion o he fuel and shor-run operaing expenses. I is clear ha sunk coss, such as capial coss, and periodic xed capial and mainenance expenses should no be included in any esimae of shor-run marginal cos. More dif cul are he impacs of various uni-commimen coss and consrains, such as he cos of saring upa plan, he maximum raes a which a plan s oupu can be ramped up and down, and he minimum ime periods for which a plan can be on or off. These consrains creae nonconvexiies in he producion cos funcions of rms. For a generaing uni ha is no operaing, hese coss are clearly no sunk. On he oher hand, i is no a all clear how, or wheher, a price-aking, pro -maximizing rm would incorporae such coss ino is supply bid for a given hour. In fac, i is relaively easy o consruc examples where i would clearly no be opimal o incorporae sar-up coss in a supply bid. 24 We do no aemp o capure direcly he impacs of hese consrains on our cos esimaes. Below, we discuss how nonconvexiies could affec he inerpreaion of our resuls. C. Impors and Expors One of he mos challenging aspecs of esimaing he marginal cos of meeing oal demand in he ISO sysem is accouning for impors and expors beween he ISO and oher conrol areas. We can, however, observe he ne quaniy of power enering or leaving he ISO sysem a each inerie poin, as well as he willingness of rms o impor and expor o and from California. If he power marke ouside of California 24 Consider a generaor ha esimaes i will be in he marke for six hours on a given day and bids ino he marke in each hour a a level equal o is fuel coss plus one-sixh of is sar-upcos. Consider he resuls if he marke price in one hour rises o a level suf cien o recover all sar-up coss, bu in all subsequen hours remains a a level above he uni s fuel coss, bu below he sum of is fuel cos plus he proraed sar-up coss. If his uni commied o operae in he one hour ha i covers is fuel coss plus one-sixh of is sar-upcoss, bu sayed ou of he marke in subsequen hours, i is no maximizing pro s, because i could have earned an operaing pro a marke-clearing prices in he ve remaining hours.

12 VOL. 92 NO. 5 BORENSTEIN ET AL.: ELECTRICITY MARKET POWER 1387 he price were insead se a he compeiive price of P comp, we would see impors a some level less han or equal o hose seen a P px. This would shif he residual in-sae demand o a quaniy q* r. Thus, in order o esimae he price-aking oucome in he marke, we need o esimae he ne impor or ne expor supply funcion. FIGURE 2. IMPORT ADJUSTMENTS AND EFFICIENCY LOSSES were perfecly compeiive, hen he marginal generaor ha is imporing ino California would, absen ransmission consrains, have a marginal cos abou equal o he marke price in California. When marke power is exercised wihin California, his would mean ha, in an effor o drive upprice, some in-sae generaors are wihdrawing (or raising he offer price on) heir marginal generaion and allowing more expensive impored power o be subsiued for i. Thus, in he absence of marke power, we would see lower impors. This means ha he cos of serving he demand ha remains afer he compeiive level of impors is need ou would be higher han he cos of serving he demand ha remains afer he rue level of impors is adjused for. 25 Figure 2 illusraes a hypoheical marginal cos curve of he in-sae generaion, excluding mus-ake (q m ) and reservoir energy resources (q rsv ). The marke demand is q o, and he observed price is P px. A a price of P px,wesee impors of q imp (5q o 2 q r ) ha shif he remaining demand o he lef o a quaniy q r.if 25 Capaciy consrains on boh he ransmission ineries ino California and he producion capaciy of non-californian producers complicae his inuiion somewha. If such a capaciy consrain were binding a he observed California marke-clearing price, hen he marginal producion cos of impors would mos likely be below his marke-clearing price and, hus, a perfecly compeiive price wihin California would yield only weakly lower impors. Esimaing he Ne Impor/Expor Supply Funcions. One of he primary responsibiliies of he California ISO is o ensure he reliable usage of he sysem s ransmission nework. This requires ha he ISO operae a marke for raioning ransmission capaciy when is use is oversubscribed. This marke is implemened hrough he use of schedule adjusmen bids, which are submied by scheduling coordinaors o he ISO along wih heir preferred day-ahead schedules. Scheduling coordinaors submi heir preferred impor or expor quaniies and he ISO checks o see wheher hese ows exceed ransmission capaciy limis. If hese proposed power ows are feasible, no furher adjusmens are required. In he even ha he ne of proposed impor and expor schedules does exceed ransmission capaciy on some inerie, he ISO iniiaes a process of congesion relief by adjusing schedules according o heir adjusmen bids. Adjusmen bids esablish, for each scheduling coordinaor, a willingness-o-pay for ransmission usage. Schedules are adjused according o hese values of ransmission usage, saring a he lowes value, unil he congesion along he inerie is relieved. A uniform price for ransmission usage, paid by all SCs using he inerie, is se a he las, or highes, value of ransmission usage bid by an SC whose usage was curailed. Adjusmen bids reveal he willingness-osupplyimporedenergy of ou-of-sae suppliers (and expored energy of in-sae suppliers) a each inerie over a wide range of quaniies, no jus a he observed ne impor/expor quaniy. For he vas majoriy of hours he aggregae ne ow is ino California for he relevan price range, so we refer o his as he impor supply curve, bu negaive impor supply (ne expor) is possible. Le he impor supply curve of scheduling coordinaor sc a impor zone z be he ne

13 1388 THE AMERICAN ECONOMIC REVIEW DECEMBER 2002 of is preferred impor quaniy and all of is incremenal and decremenal adjusmen bids ino California from z. (2) q z sc ~ p! 5 q z sc,ini 1 O pˆ, p 2 O pˆ. p q z sc,dec ~pˆ!. q z sc,inc ~pˆ! In oher words, he preferred level of impors from sc a z a a price of p, would be is scheduled impors, which are independen of price, plus he amoun of addiional supply i is willing o provide in exchange for receiving a paymen less han or equal o p, minus he amoun of reducion in supply ha i would agree o in exchange for making a paymen ha is greaer han or equal o p. The aggregae ne impor curve ino he California ISO sysem for any hour can be calculaed by summing he value of q z sc ( p) over all ineries and SCs: (3) q imp ~p! 5 O sc O z q z sc ~ p!. This aggregaion consiues an upper bound on he responsiveness of ne impors o changes in he California price. The ISO is in pracice prevened from subsiuing impor adjusmen bids across individual scheduling coordinaors or across ransmission ineries, so ha he acual impor supply curve will be a signi canly seeper funcion of price han he curve consruced as described. The ISO will only ac in he even ha he iniial schedules indicae ha congesion will arise, even hough he adjusmen bids may indicae a poenial Pareoimproving impor adjusmen. Thus, while our aggregae impor supply curve assumes ha all impors from all locaions are perfec subsiues, and ha hese impors are priced a marginal cos, realiy falls shor of his level of impor ef ciency One consequence of his is ha he impor quaniies implied by he aggregae of he adjusmen bids do no exacly equal he impors ha are acually observed. To realign he impor supply curve implied by he adjusmen bids wih he observed impor-price pair for each hour, we calculae he change in impors in each hour as Dq imp ( p) 5 Our analysis assumes ha wholesale elecriciy suppliers ouside of California are price-akers, so ha he impor supply curve represens he aggregae marginal cos curve of suppliers ouside of California ne of heir naive load obligaions. Some observers have argued ha he suppliers of elecriciy ouside of California may exercise marke power (i.e., offer power a above heir marginal cos) when selling ino he California marke. If his is he case, hen an impor supply curve ha re eced no marke power from ou-of-sae suppliers would indicae a greaer supply of impors a every price and herefore a lefward shif in he residual demand curve in Figure 6, which would lower he compeiive benchmark price. Thus, our reamen of impors will end o bias downward our esimaes of he exen of marke power. D. Hydroelecric and Geohermal Generaion Reservoir generaion unis (i.e., hydro and geohermal unis) presen a differen challenge because he concern is no over a change in aggregae oupu relaive o observed levels bu raher a reallocaion over ime of he limied energy ha is available o hem. Thus, he bids of hydro unis do no re ec a producion cos bu raher he opporuniy cos of using he hydro energy a some laer ime. In he case of a hydro rm ha is exercising marke power, his opporuniy cos would also include a componen re ecing ha rm s abiliy o impac prices in differen hours. 27 I is imporan o noe ha even he acual observed bid prices of a small, price-aking hydroelecric rm operaing in an oligopoly marke would provide lile informaion abou is opporuniy cos of he energy if he enire marke were perfecly compeiive, because he acual opporuniy cos of waer for hese unis will be in- uenced by he expecaion of fuure prices, q imp ( p) 2 q imp ( p acual ), where p acual is marke price during he hour under consideraion. This adjusmen ensures ha a prices equal o he acual observed price for ha hour, here would be no change from he observed level in impors when performing our counerfacual price calculaion. A posiive Dq imp ( p) implies an increase in ne impors relaive o he observed price. 27 See Bushnell (2003).

14 VOL. 92 NO. 5 BORENSTEIN ET AL.: ELECTRICITY MARKET POWER 1389 which in urn will be impaced by he abiliy of oher rms o raise hose prices. For hese reasons, we make he assumpion ha he acual, observed oupu of hese resources is he oupu ha would be produced by a price-aking rm paricipaing in a perfecly compeiive marke. In pracice, his assumpion means ha in consrucing our esimae of he marginal cos of meeing load in any given hour we apply he observed producion of hydro and geohermal resources for each hour and hen calculae he marginal cos of saisfying he remaining demand wih he sae s fossil-fuel resources. We give he inuiion here for why his assumpion biases downward our esimaes of producive inef ciency and marke power. A more deailed explanaion is in Appendix C. For he purpose of calculaing he impac of marke power on oal producion cos, i is easy o see ha his is a conservaive assumpion,one ha will produce downward-biased esimaes on he ef ciency effecs of marke power. The opimal hydro schedule will, by de niion, lead o weakly lower producion cos han any oher hydro schedule. To he exen ha acual producion differed from he opimal schedule, i could only raise oal producion cos. Thus our assumpion will bias upward our esimae of perfecly compeiive producion cos. For he purpose of measuring marke power, we need o consider he impac of our assumpion on our esimaes of marginal producion cos. Of concern is he possibiliy ha he observed hydro schedule (which may include a response by hydro rms o he exercise of marke power by ohers) when combined wih a counerfacual perfecly compeiive producion of fossil-fuel resources couldproducea lower marginal cos esimae on average han he opimal hydro schedule. However, i is sraighforward o show ha when sysem marginal producion coss from nonhydro sources are convex in quaniy, any reallocaion of hydro energy away from he leas-cos allocaion will raise marginal coss more in he hours from which energy is removed han i will reduce marginal cos in he hours o which energy is added. 28 Thus our assumpion of opimal hydro producion can only bias our ime-weighed esimaes of marginal cos upwards, and herefore our esimaes of price-cos margins downward. We presen resuls in which price-cos margins are weighed by he marke volumes in each hour. To consider he effec of our hydro assumpions on hese resuls, we need o address he possibiliy of a reallocaion of hydro energy beween off-peak and peak hours relaive o he opimal schedule. A hydro rm ha is aemping o exercise marke power would likely allocae less hydro energy during peak hours han would be he case for a price-aking rm (see Bushnell, 2003). This sraegic hydro allocaion, when combined wih compeiive fossil-fuel producion, would produce a higher weighed average of marginal cos han would he opimal schedule. To he exen he rms conrolling hydro resources aemped o exercise marke power wih hose resources, our resuls will herefore undersae he overall level of marke power. However, he vas majoriy of reservoir resources were conrolled by he PG&E and SCE, each of which had a fairly srong incenive o lower wholesale power coss. Therefore i is possible ha hese rms responded o an increase in marke power wih an overconcenraion, relaive o perfec compeiion, of energy during high-demand periods. As argued above, his reallocaion (if allowed by he ow consrains) would raise off-peak marginal coss more han i would lower on-peak marginal coss. However, since (non-mus-ake) marke volumes are likely o be higher on-peak, he impac on he quaniy-weighed average of marginal cos is uncerain. We examined his issue empirically by asking wheher our esimaes of marginal coss produce opporuniies for a reallocaion of hydro energy ha would resul in a lower weighed-average marginal cos. Such an opporuniy would exis if fossil-fuel marginal coss during some highdemand period were lower (due o overproducion from hydro sources) han he marginal cos in some lower-demand period. If, by conras, 28 This is because a he leas-cos allocaion of hydro energy, marginal fossil-fuel coss will be equalized over all hours for which hydro ow consrains allow a discreionary use of hydro energy.

15 1390 THE AMERICAN ECONOMIC REVIEW DECEMBER 2002 our marginal cos esimaes (over a period wih sable inpu prices) were monoonic in marke demand, hen no sysemaic opporuniy for lowering he weighed average of marginal cos exiss and any bias from our hydro assumpion is in he direcion of raising coss and lowering marke power. To examine his possibiliy, we esimaed a kernel regression of our esimaed marginal cos (i.e., compeiive price) on sysem demand (presened in Appendix C) in order o deec wheher in aggregae here are sysemaic deviaions from a monoonicallyincreasing relaionshipbeween demand and our esimae of sysem marginal cos. Such regressions for each of he hree summers in our sample period show ha our sysem marginal cos esimaes were monoonically increasing in demand for each of hese ime periods. This leads us o conclude ha i is highly unlikely ha our assumpion ha he acual schedule of producion reservoir resources was he cos-minimizing schedule creaes a signi can negaive bias on he weighedaverage esimaes of sysem marginal coss. E. Calculaing Cos Increase Relaive o Compeiive Oucome Uilizing he assumpions oulined in he previous secions, we esimaed he perfecly compeiive marke price in he California energy markes for each hour of marke operaion from June 1998 hrough Ocober The residual marke demand o be me by in-sae fossil-fuel unis wihin he ISO sysem in hour, q ff, is esimaed o be (4) q ff ~ p! 5q o 1 q reg 2 q m 2 q rsv 2 q impac 2 Dq imp ~ p!. Here q o is he acual ISO meered generaion (including ne impors), including generaion scheduled hrough all energy markes associaed wih he ISO conrol area, including he PX, ISO imbalance energy marke, and oher SCs. q reg represens he addiion o demand due o he need for capaciy dedicaed o regulaion reserve. The quaniies q m and q rsv represen he amoun of energy produced by mus-ake generaion and by reservoir generaion, respecively. These quaniies are all reaed as price inelasic. The erm q impac 2 Dq imp ( p) ishe level of impored energy adjused by he response o changes in he marke-clearing price, as described above. For each hour, we make 100 fossil-fuel generaion marginal cos curve esimaes, each re- ecing a combinaion of independen Mone Carlo draws for he ouage of each generaion uni. For each of hese draws from he sysemwide fossil-fuel marginal cos curves we compue he inersecion of his marginal cos curve wih he residual marke demand curve q ff ( p). This yields an esimaed marginal cos and an in-sae marke-clearing quaniy q rj for Mone Carlo draw j. We denoe he marginal cos associaed wih his quaniy as C j. We can hen compue an esimae of he expeced value of he marginal cos of meeing he in-sae demand ha resuls from price-aking behavior by in-sae generaors as: (5) P# comp j 5 1 ~C j! 100 Noe ha here are cases in which P px. 2 P# comp is negaive in our simulaions. Absen an operaional error or an aemp a predaory pricing, rms will no acually be willing o sell power a prices below heir rue economic shor-run marginal coss. In oher words, prices will no be below he perfecly compeiive price. Noneheless, during some hours, paricularly June 1998 and during he winer and spring of 1999, PX prices were below our esimaes of he perfecly compeiive marke price. A leas hree facors conribue o hese oucomes. Firs, our cos esimaes can exceed he acual marginal cos because we do no consider he dynamic effecs of uni commimen consrains, such as sar-upcoss, ramping raes, and minimum down imes. These consrains can creae opporuniy coss of shuing down unis ha, in essence, lower he rue marginal cos of operaing ha plan. Of course hese same consrains also can creae opporuniy coss ha, a oher imes, raise he rue marginal

16 VOL. 92 NO. 5 BORENSTEIN ET AL.: ELECTRICITY MARKET POWER 1391 cos. This is one reason why we include he negaive markups in our resuls; we did no wan o exclude he off-peak impac of hese consrains on our cos esimaes, since here is an opposie effec on our esimaes during peak hours. Second, cos informaion for generaing unis are no exac daa on which all paries agree. For he mos par, we used values submied o sae and federal regulaory agencies under he former regulaed regime. For his reason, our esimae of a uni s marginal cos may be slighly higher han he cos level a which i is capable of operaing in a marke environmen. Therefore we include negaive price-cos differences in order o preven runcaing he effec of daa uncerainy on our cos esimaes. Third, and probably mos imporan, our calculaions do no conrol separaely for he oupu levels of reliabiliy mus-run (RMR) generaion. Some fossil-fuel generaion unis have been declared mus-run for local grid reliabiliy under cerain sysem condiions. These generaors ge separae nonmarke paymens when hey are called under he RMR conracs hey have signed wih he ISO. RMR unis are no dispached hrough he price-seing process. Because hey are held ou and paid a differen price, he resuling price in he PX can be below he marginal cos o he sysem if he power provided by RMR unis were insead provided as par of he full dispach of he sysem. In fac, due o he level of RMR calls by he ISO during some periods during our sample, paricularly he spring of each year, i is possible ha no oher fossil-fuel generaion was economic during hese ime periods. Under hese circumsances, he highes (opporuniy) cos unis selling in he PX could be hydro or ouof-sae coal plans, eiher of which have lower marginal cos han any of he fossil-fuel plans we examine. However, hese periods are likely o occur when he PX price is exremely low, no exremely high. In such cases, impor energy wih coss below hose of in-sae fossilfuel generaion could be he marginal generaion, and he acual PX price could be lower han he marginal coss of any of he fossil-fuel unis we have examined. Because we don accoun for he RMR unis, our esimaes could sill indicae ha a fossil-fuel uni is marginal and is cos is he sysem marginal cos, so our esimaed sysem marginal cos would be above he acual PX price due o unaccouned for RMR calls. 29 If he esimaed MC is above he PX price for eiher he rs or second reason, hen i seems ha he mos accurae esimae of marke power would come from including he negaive marke power oucomes in our calculaions. However, oal sar-upcoss for he fossil-fuel unis in California are abou $39 million during our sample period, less han 1 percen of oal fossilfuel generaion producion coss during he period and less han 1 percen of he marke power rens we nd. 30 In addiion, here are oher reasons o hink ha sar-upcoss explain only a minor par of he deviaions from marginal cos pricing. Firs, he unis ha urn on o mee peak demand during he summer have lile sar-upcoss (fuel oil or je fuel unis) or none a all (hydroelecric unis), so he impac a he imes we nd he greaes marke power is likely o be low. 31 Second, our esimaes of marke power are subsanially greaer in summer 2000 han in summer 1999, bu he amoun of elecriciy produced per sar-up is 5.7 percen lower in summer 1999, implying ha sar-upcoss would likely be a greaer facor in 1999 han in Similarly, he raio of sar-upcoss o our esimaed fossil-fuel producion coss was 29 This implies ha neglecing RMR calls could underesimae marke power. In addiion, i appears ha he iniial RMR agreemens exacerbaed some of he local marke power problems ha hey were designed o miigae. See Bushnell and Wolak (1999). 30 For 65 of he 92 unis in our fossil-fuel cos curve, he uni-speci c formulae for deermining he cos per sar-up (as a funcion of boh inpu fuel coss and he price of elecriciy) were submied o he ISO as par of he RMR conrac renegoiaion process. For he remaining 27 unis, we esimaed he uni-speci c sar-up formula by using parameers from a similar uni ha did have an RMR conrac. We used he daily price for he inpu fuel used by ha uni and daily average annual reail price o indusrial cusomers for he elecriciy price in he sar-up cos formula. 31 Addiionally, if marginal cos funcions urn upward smoohly around he raed capaciy, raher han having a sric L-shape, he ypical argumen ha a compeiive plan would bid is sar-upcoss for he single hour i would run are incorrec. In ha case, even he las plan urned on would run for many hours because i would be replacing higher-cos oupu from oher plans ha would oherwise be producing along he seepes pars of heir MC curves.

17 1392 THE AMERICAN ECONOMIC REVIEW DECEMBER 2002 higher in summer 1999 han in summer 2000, 0.91 percen versus 0.37 percen. Likewise, i is unlikely ha much of he negaive marke power oucomes could be he resul of cos-daa errors. Many PX prices in June 1998, for insance, were well below he coss ha anyone has claimed for operaion of fossilfuel generaing unis. 32 Thus, i is mos likely ha he cos esimaes ha exceed he PX price occur because here were no fossil-fuel generaing unis ha were economic o run a he ime. Only fossil-fuel unis running under RMR conracs were acive. In ha case, he marginal cos of he sysem, and hus he marke price, is being se by much cheaper ou-of-sae coal plans, by nuclear plans, or by hydro or geohermal plans. If his is he case, hen he proper reamen would be o runcae he resuls, reseing any nding of negaive marke power o se marginal cos equal o price. Sill, in order o avoid biasing he resuls in favor of nding marke power, we do no runcae he negaive oucomes in he primary resuls we repor. IV. Resuls We compued he expeced perfecly compeiive price each hour for he monhs of June 1998 hrough Ocober 2000 using he algorihm described above. From he impor adjusmen bids, he median hourly reducion in impors from he observed level a he PX price versus he level a our esimaed compeiive price was 2.4 percen. For each hour, we can calculae an arc elasiciy implied by he adjusmen bids for he impor response from he change beween he compeiive and acual price and he resuling change in impors. The median arc elasiciy of impor supply for hese hours is The added wholesale cos of energy due o deparures from a compeiive marke, DTC, is calculaed by aking he difference beween he PX price and our esimae of compeiive benchmark price and muliplying i by he oal ISO 32 If we were o ignore any negaive marke power oucomes for prices below, say, $18/MWh, virually all of he negaive marke power effecs would be eliminaed. 33 We calculae he arc elasiciy as ~P 1 1 P 2!/2 ~Q 2 2 Q 1! ~Q 1 1 Q 2!/2 ~P 2 2 P 1!. meered generaion less he mus-ake energy for ha hour. 34 Tha is, for hour, (6) DTC px 2 P# comp # o 2 q m #, where P# comp is he expeced compeiive price in period. This expecaion is aken wih respec o he disribuion of generaing uni ouages, as shown in (5). For any se of hours, our measure of marke performance is (7) MP~! 5 [ [ DTC TC. MP( ) is he proporional increased wholesale cos of elecriciy during all hours in. De ning MP( ) in his manner is consisen wih he view, re eced in our compeiive benchmark Mone Carlo simulaion, ha he observed marke price is condiional on a realizaion from he join disribuion of generaing uni ouages. To re ec his fac, le Pˆ px denoe he observed PX price for hour and E(Pˆ px ) he ex- pecaion of his magniude wih respec o he join disribuion of generaing uni ouages. Unlike he counerfacual case of price-aking behavior, we canno draw from he disribuion of generaing uni ouages and compue a disribuion of marke prices ha re ec he curren level of marke power. This would require a model for he sraegic ineracion among players in he California marke. However, by de- ning MP( ) as shown in equaion (7), we can ake advanage of he law of large numbers o prove ha our measure is a consisen esimae of he proporional cos increase. To show his, rewrie he index as: (79) MP~! 5 1/Card~! px 1/Card~! [ 2 P# comp # o Pˆ px o 2 q m # 2 q m # 34 By aking he observed quaniy as he marke demand, we are, for he reasons discussed earlier, implicily assuming ha demand is price inelasic.,

18 VOL. 92 NO. 5 BORENSTEIN ET AL.: ELECTRICITY MARKET POWER 1393 TABLE 2 ACTUAL PRICE AND ESTIMATED MARGINAL COST Monh Year Mean of Acual Producion Per Hour (MWh) Mean of PX Price ($/MWh) Mean of Marginal Cos ($/MWh) Sum of DTC ($ million) Aggregae DTC/TC (percen) June , July , Augus , Sepember , Ocober , November , December , January , February , March , April , May , June , July , Augus , Sepember , Ocober , November , December , January , February , March , April , May , June , , July , Augus , , Sepember , Ocober , where Card( ) is he cardinaliy or number of elemens (hours) in he se. For ses wih a large number of elemens, he index is approximaely equal o (70) MP~! 5 px [! 2 P# comp # o E~Pˆ px! o 2 q m # 2 q m # which is equal o he raio of he expeced cos increase relaive o he perfecly compeiive benchmark, due o he curren level of marke power and marke imperfecions, dividedby he expeced cos of purchasing elecriciy under curren marke condiions. Table 2 repors he PX price, esimaed marginal cos, and he added cos of power due o prices ha exceeded marginal cos for each monh in he sample period. As is eviden from Table 2, June 1998 produced very idiosyncraic resuls, wih an average PX price considerably below our esimae of marginal cos. The marke was only in is hird full monh of operaion a his ime and a number of fossil-fuel generaion unis were going hrough ownershipransfer and regulaory approval of hese ransfers. The CTC mechanism provided he hree invesor-owned uiliies wih an incenive o induce low energy prices and he uiliies were sill operaing and bidding many of hese unis hrough June As described above, he use of reliabiliy mus-run conracs, which paid some fossil-fuel unis o run in exchange for

19 1394 THE AMERICAN ECONOMIC REVIEW DECEMBER Appendix B oulines our procedure for compuing his sandard error, which accouns for he error associaed wih he randomness of forced plan ouages. FIGURE 3. KERNEL REGRESSIONS OF LERNER INDEX, AUGUST 7 SEPTEMBER 30 paymens ha were above he marke price, was also widespread during June. For hese reasons, we believe he marke resuls from June 1998 do no provide much meaningful informaion on he sae of compeiion in he California marke. Neverheless, for compleeness, we have included hese resuls. For he se of all hours over he enire 29-monh period from June 1998 o Ocober 2000, he MP( ) is equal o 33 percen, amouning o oal paymens in excess of compeiive levels equal o $5.55 billion wih a sandard error of $1.19 billion. 35 Having generaed esimaes of price-cos margins for each hour of he 29-monh sample period, we can examine subses of he daa o gain insigh ino he underlying dynamics of he marke. One es of he credibiliy of our resuls is wheher our esimaes of marke power vary in he way ha economics would predic. We would expec marke power o be quie low during he off-peak monhs, December hrough April. Elecriciy demand is low in hese monhs and supply is relaively large due o he resurgence in hydro producion from winer rains. In December 1998 April 1999, we nd an average MP( ) of 1.9 percen, and in December 1999 April 2000, we nd an average MP( ) of 1.8 percen, neiher of which is signi canly differen from zero. Thus, we nd ha here was essenially no margin beween prices and marginal cos during he period in which supply was mos abundan compared o demand and sellers had he leas abiliy o exercise marke power. In addiion, hese resuls provide evidence ha signi can shor-run operaing coss are no missing from our cos esimaes, because negaive or zero margins would no be observed over such an exended period of ime. The series of evens ha led o he California elecriciy crisis in began wih dramaic price increases during he summer of Many policy makers and regulaors have argued ha he compeiive performance of he marke fundamenally changed during summer 2000, hereby iniiaing he crises. In order o make such comparisons, however, one mus accoun for differences in he relaive levels of demand during hese periods. As described above, we would expec he esimaed marke power o increase as he demand faced by in-sae nonuiliy sellers rises relaive o he capaciy of hese players. Figure 3 shows a kernel regression of his relaionshipfor lae summer of 1998, 1999, and The horizonal axis of Figure 3 is he demand faced by hese rms afer accouning for acual impors, mus-ake, and reservoir producion. The verical axis is he raio DTC /TC, which is equal o he Lerner index for ha hour. 37 The resuls summarized by his gure show ha marke power seadily increased wih he demand faced by he nonuiliy in-sae suppliers consisen wih he earlier discussion of he naure of compeiion in he elecriciy indusry. During lower demand hours and monhs, as well as springime monhs when signi can hydro energy is available, no single rm can affec prices signi canly. During higher demand hours, however, compeiive sources of energy begin o reach heir capaciy limis and he pool 36 To be precise, he daa are for Augus 7 hrough Sepember 30 of each year. We focus on his period because he ISO energy price cap varied during our sample period, bu i was se a he same level, $250/MWh, for Augus 7 hrough Sepember 30 of all hree years. Augus and Sepember are hisorically wo of he highes demand monhs of he year in California, and hey can exhibi he lowes supply availabiliy due o declining hydro resources lae in he summer. 37 Because he Lerner index is no symmeric around zero, negaive values of he raio are se o zero in esimaing he kernel regressions.

20 VOL. 92 NO. 5 BORENSTEIN ET AL.: ELECTRICITY MARKET POWER 1395 FIGURE 4. CUMULATIVE DISTRIBUTION FUNCTIONS (CDFS) OF DEMAND MET BY IN-STATE FOSSIL-FUEL PLANTS, AUGUST 7 SEPTEMBER 30 of poenial compeiors for addiional supply dwindles. Because of he lack of signi can sorage capaciy and he inelasiciy of demand, rms can ake advanage of he capaciy limis of heir compeiors during hese high-demand hours. This is consisen wih he effecs deeced from he oligopoly equilibrium simulaions in Borensein and Bushnell (1999). This sequence of evens does no imply a shorage of generaing capaciy o serve he energy or ancillary services needs of he California ISO conrol area. However, he combinaion of he concenraionof ownershipof generaing asses and he level of demand did combine o creae circumsances where one or more marke paricipans recognized ha heir capaciy was needed o mee he ISO s energy and ancillary services needs regardless of he acions of oher marke paricipans. Under hese circumsances, rms nd i in heir unilaeral ineres o bid o raise prices even hough here is suf cien capaciy available o mee he California ISO s oal energy and ancillary services requiremens. Our resuls also indicae ha, given he supply and demand condiions during ha period, he performance of he marke was no dramaically differen in 2000 from ha in 1998 and Figure 4 shows he cumulaive disribuion funcions for he demand me by in-sae fossil-fuel generaion for he lae-summer period during Alhough oal marke demand was only 6 percen higher during lae summer 2000 han in lae summer of 1999 and 5 percen higher during ha period in 1998, he demand me by in-sae fossil-fuel plans, nearly all of which were unregulaed by 1999, increased from an average of 6,639 MWh during 1998 and 5,690 MWh during 1999 o 10,007 MWh during This is largely due o a subsanial decline in impors from an average of 5,069 MWh in 1998 and 6,764 MWh in 1999 o 3,627 MWh in Thus, alhough he performance of he marke conrolling for he demand faced by in-sae fossil-fuel generaion did no change signi canly during 2000, he disribuion of his demand did change. Far more hours spen a higher residual demand levels creaed larger average margins during This combined wih he fac ha marginal coss also nearly ripled beween 1999 and 2000, which mean ha similar Lerner indices re eced much larger absolue dollar margins, producing exremely large wealh ransfers. V. Deadweigh Loss and Ren Division Even wihou a marke power analysis, i is clear ha he exraordinary prices ha began in he summer of 2000 creaed large ransfers of wealh. The analysis we have carried ou, however, allows us o parse he changes in wholesale paymens for elecriciy beween hree muually exclusive and exhausive caegories: changes in he compeiive cos of generaing elecriciy, changes in he level of compeiive inframarginal rens (which would have occurred wihou any marke power), and changes in seller rens due o he exercise of marke power. Some of he rens due o marke power became pro s of elecriciy producers or markeers, bu some were dissipaed in producion ef ciency losses: ef ciency losses resuling from he operaion of higher-cos producion unis when a rm wih lower-cos producion exercises marke power and resrics oupu. A. Deadweigh Loss We begin by esimaing he loss in economic ef ciency due o he imperfecions in he marke. Because he demand for elecriciy in he California marke was effecively perfecly inelasic wih respec o he wholesale marke