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Review of Industrial Organization

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20-06-2017

Analyzing the Impact of Electricity Market Structure Changes and Mergers: The Importance of Forward Commitments

Authors: David P. Brown, Andrew Eckert

Published in: Review of Industrial Organization | Issue 1/2018

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Abstract

We investigate how the effects of market structure changes and mergers in restructured electricity markets depend on the level of forward contracting. We develop a Cournot model of Alberta’s wholesale electricity market that incorporates firms’ forward positions. Using data from 2013 to 2014, we calibrate the forward positions of the five largest firms and simulate the effects of different market structure changes, including a hypothetical merger with asset divestitures. We examine the sensitivity of the simulated effects to assumptions with regard to the firms’ forward commitments. The wholesale market effects of these transactions depend critically on firms’ forward commitments. These results demonstrate the importance of establishing a clear understanding of the size and nature of forward commitments in forecasting the effects of mergers and other market structure changes in wholesale electricity markets.

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This concern could also arise in other commodities markets that can be concentrated, including natural gas and markets for certain metals. See for example Slade and Thille (2006) and Van Eijkel et al. (2016).

In the United States, the electricity industry has been subject to a recent wave of consolidation through mergers (EIA 2013). For example, the recent merger of Exelon and Constellation was valued at $8 billion dollars. Wolak (2011) demonstrated that this merger raised significant antitrust concerns and emphasized the importance of the merging firms’ forward contracts.

Under virtual divestitures, the buyer purchases from the owner of a power plant the right to sell power for a portion of the asset’s capacity and for a pre-specified period of time (e.g., 20 years in Alberta). The sale of the capacity is virtual because no physical production capacity changes hands. Rather, the buyer of the virtual capacity can sell power into the wholesale market, while the physical operation of the asset remains with the owner. The buyer of the virtual asset earns the wholesale price on production and pays the owner of the asset for the variable and fixed costs of maintaining the asset (Ausubel and Cramton 2010; MSA 2012).

See for example Ausubel and Cramton (2010) and Frutos and Fabra (2012) for a discussion of the extent of virtual divestitures in different jurisdictions and the associated economic issues.

Alternatively, numerous jurisdictions provide capacity payments that compensate generators for the capacity that they provide to the power system, in addition to revenues they earn in energy markets. This alternative market design aims to correct for market imperfections that arise in energy-only markets; see Joskow (2008) for details.

See MSA(2012, pp. 30–33) and Appendix 2 for a discussion of forward contracting in Alberta.

Commonly traded forward products include flat products that provide a fixed quantity in every hour of the contract period (e.g, a month) and peak and off-peak products that provide a fixed quantity for peak or off-peak hours (MSA 2010).

This flexible modeling approach comes at a cost: Our calibrated forward positions lack the statistical properties that are necessary to carry out statistical inference.

Others have utilized econometric techniques to estimate firms’ forward positions (Hortacsu and Puller 2008; Allcott 2012). However, these approaches often limit the model complexity and require closed-form solutions. Recent literature begins to fill the gap between parameters estimated with the use of mathematical programming and econometrics. Reguant (2014) establishes an innovative econometric approach to model non-convexities in firms’ marginal cost to model bidding behavior in electricity markets. Su and Judd (2012) demonstrate that an econometric approach that is commonly used to estimate parameters in structural models yields the same parameter estimates as those that are obtained by solving a mathematical program that is similar to ours.

We do not explicitly define the distribution of the stochastic process that generates the deviations of our model’s estimated production decisions from observed output (e.g., due to idiosyncratic cost shocks). We utilize advances in mathematical programming methods to calibrate forward positions that rely on standard nonlinear optimization techniques (Ferris et al. 2005). A detailed characterization of the distribution of our calibrated forward positions is beyond the scope of the current analysis.

The system of constraints that are defined in (7)–(10) represents a “square” complementarity program. In the numerical program we verify that the each firm’s profit functions are globally pseudoconcave and locally strictly concave at the solution to the MPCC. This ensures that the Cournot–Nash equilibrium exists and is unique (Kolstad and Mathiesen 1991).

To alleviate concerns that our calibrated forward positions are sensitive to the starting values selected, we also utilize a solver called KNITRO which has a multi-start algorithm which randomly selects starting values for all endogenous variables and then launches the Levenberg–Marquardt algorithm to search for the solution to the MPCC from this starting point (Xian et al. 2004). For each month in our sample, we use the multi-start algorithm to solve the MPCC 100 times. We find systematic convergence to the same forward positions regardless of the starting values.

The large difference between the minimum and maximum observed market-clearing wholesale spot prices arise because of the heterogeneous portfolio of generation assets, market power execution, and periodic scarcity events triggering a price equal to the price-cap of $999.99. Wholesale spot electricity prices exhibit greater dispersion than natural gas prices because they reflect natural gas prices as well as these other factors.

See Appendix 1 for additional details on the data sources that are used to estimate unit-level marginal costs.

All wind facilities and the majority of cogeneration units offer all of their production at a price of zero into the wholesale market, although several cogeneration units produce electricity beyond their on-site needs and submit non-zero bids. For these units, because they operate on natural gas we use unit-specific heat rates and natural gas prices to impute their underlying marginal cost as we would with a traditional natural gas facility.

This implies that we apply the observed output of hydro for each hour and investigate the non-hydro units needed to satisfy the remaining demand. The potential biases from this assumption are likely to be small in Alberta due to the limited Hydro generation. Hydro makes up 6–7% of generation capacity and 2–3% of annual generation output in Alberta.

Wolfram (1999) and Bushnell et al. (2008) use the forced outage factor (fof) to reflect the probability of a complete unit forced outage. We use Canadian generation unit data on fof’s that are derated to account for partial unit outages (CEA 2012).

TransCanada’s R-squared increases to 0.94 with the removal of a 30-MW high marginal cost biomass unit that fits poorly in our polynomial approximation.

Limited imports from Montana are included in the estimation of the BC import supply function.

The linear specification is chosen for computational ease. Alternative specifications such as log-linear increase the computational complexity of the bilevel Cournot optimization substantially. A log-linear specification increases the price-elasticity of imports (and hence, the elasticity of residual demand). While this reduces the level of implied forward contracts, the key qualitative conclusions of the analysis persist. See Sect. 8.3 for a related discussion.

The cities considered in AB, BC, and SK are Calgary, Edmonton, Vancouver, and Saskatoon, respectively. The results of the analysis are robust to the consideration of alternative large cities in each province and higher degree polynomials.

This is particularly relevant in the current context because imports from BC and SK arise primarily from hydro and fossil fuel generators, respectively. If the imports arose from wind production, the strong geographical correlation that is observed in wind output would raise concerns over the validity of our IVs.

When solving the perfectly competitive equilibrium, this problem takes the form of a Mixed Complementarity program and is solved using Newton’s Method and the PATH algorithm in GAMS.

We also compared the observed and model estimated firm-specific Lerner Indices $\left( \frac{P_t-C^\prime _{jt}(q_{jt})}{P_t}\right)$ for all $j = 1, 2,\ldots , 5$. We find that our model captures the heterogeneity in firm-specific behavior well. These results are available upon request.

Similar to Bushnell et al. (2008), we find that the Cournot model with no forward commitments fits the data poorly; for almost all hours in our sample, the Cournot model with zero forward commitments yields prices that exceed the price-cap of $1,000. This supports prior literature that emphasizes the importance of accounting for forward commitments.

The marginal cost of coal units includes dynamic (non-convex) costs that are associated with ramping and turning on and off inflexible coal units. Mansur (2008) uses a reduced-form approach to illustrate the importance of accounting for these start-up costs and ramping constraints, especially in off-peak periods when coal units set prices. Due to computational complexity, we are unable to account for these non-convex costs.

While the fit of the Cournot model for certain variables is statistically different in peak and off-peak hours, the average difference between observed and estimated outcomes is smaller for Cournot than the perfectly competitive model.

The largest deviation between the Cournot and observed outcomes is in the Fringe’s output. This is the result of two factors: First, we overestimate prices on average and particularly in off-peak hours when the fringe is not capacity constrained. Second, our approach to exogenously defining hourly capacity availability results in expected fringe capacities that exceed observed capacities over our sample period by approximately 5%.

See Werden et al. (2004) for a related discussion.

The calibrated forward positions remained largely unchanged with the exclusion of the hours with the highest 5% of demand. The 5th and 95th percentile differences in forward positions from our baseline estimates were −14.46 and 22.32 MWs (−1.58 and 1.51%).

TransAlta may prefer to produce at a loss for several hours rather than shut down its coal assets. Our model would attribute this behavior to having a high forward contract position. Reguant (2014) emphasizes the importance of future research that incorporates these dynamic non-convexities when modeling firms’ marginal cost functions.

The calibrated forward positions exhibit lower variation than the overall NGX market. The average monthly percentage change in total forward traded MWs on the NGX is 19.2%. More detailed information on the variation in the calibrated forward positions are available upon request.

Willems et al. (2009) uses both a Supply Function Equilibrium (SFE) and Cournot model to model firm behavior. The authors find forward contract positions of around 25% of installed capacity for the SFE model and 50% for the Cournot Model.

The results for the off-peak hours are qualitatively similar to peak hours. These results are available upon request.

We utilize prior literature that analyzes how firms’ forward commitments change in the presence of a merger to guide our initial comparative statics (e.g., see Brown and Eckert 2017).

The combined market share of the top 4 firms was 54.7% in 2013 and 54.1% in 2014. Further, the Herfindahl–Hirschman Index (HHI) was 939.5 in 2013 and 933.4 in 2014 (MSA 2014).

A comparison of bidding by BR3 and BR4 in 2013 and 2014 suggests there was a sizable change in the offer behavior of these units. However, other explanations for this change in behaviour exist, including the observation that maintenance outages for these units increased after the expiration, which further motivates the use of this counterfactual analysis.

An exogenous change to a firm’s generation portfolio due to an asset-level PPA contract expiration could affect its firm-level contracting decision. Section 8.1 considers changes to firm-level forward contracts as a result of the PPA expiration.

Section 8.2 analyzes the changes in profits and total costs in the divestiture and no-divestiture cases.

In all cases, all of the firm’s profits increase. ATCO’s (ENMAX’s) total costs decrease (increase) because it gains (loses) low-cost base-load coal assets. The increase in market power execution causes a small increase in total production costs. Detailed results are available upon request.

Further reductions in AE’s forward quantities can result in the merger with divestiture increasing price. For example, reducing the merged firm’s forward MWs by 40%, which is less than the 50% assumed in Wolak (2011), results in an average price of $89.51.

Note however that the degree of inelasticity of our residual demand curve is consistent with the results for U.S. markets, with the exception of California, which exhibits a much higher reliance on imports. See for example Bushnell et al. (2008).

This result will not necessarily hold if assets are divested to a large dominant firm that has large amount of forward commitments. However, if the dominant firm is able to adjust its forward contracts after acquiring the assets, the asset divestiture to a dominant firm may result in more market power compared to asset divestiture to the competitive fringe.

Brown and Olmstead (2017) use 2008–2014 data from Alberta’s electricity market and a Monte-Carlo approach that selects unit-specific non-zero coal bids into the wholesale market in low demand hours to represent each coal unit’s marginal costs. The authors demonstrate that this approach results in marginal cost estimates that closely reflect estimates that are obtained with the use of coal unit heat rates and PRB coal prices.

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Title: Analyzing the Impact of Electricity Market Structure Changes and Mergers: The Importance of Forward Commitments
Authors: David P. Brown
Andrew Eckert
Publication date: 20-06-2017
Publisher: Springer US
Published in: Review of Industrial Organization / Issue 1/2018
Print ISSN: 0889-938X
Electronic ISSN: 1573-7160
DOI: https://doi.org/10.1007/s11151-017-9580-1

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