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Market power in Irish electricity: proposals for regulation

This entry was added to on 8 February 2006
Full blog table of contents available at Contents | viewpoint: Franck.

Update, April 2006: The regulators' conclusions make rather more sense than the draft conclusions criticised below.

Back in August 2005 I made some critical comments about a consultation paper issued by the electricity industry regulators of Northern Ireland and the Republic of Ireland which sets itself an objective "to help identify the issues relating to market power that might affect the all island market and in particular the [single Irish electricity market], and to consider appropriate regulatory remedies that might be developed to address those concerns". That paper, in my view, failed to achieve these worthy objectives.

The regulators published their draft conclusions last week about proposed measures to mitigate market power once the single electricity trading and settlement area for the island of Ireland is established.

I have finally got around to reading that paper. My objection to the August paper was that it promised much more analysis than it delivered. This latest paper delivers 85 pages, and some reasonably specific proposals, so there is no complaint about quantity. But what it delivers is not very good.

Preliminary issue: the paper is barely intelligible in places

Given the length of the paper, I looked for a shortcut to see what it was all about. Choosing what to read was easy: page 66, section 11.7 is advertised in the table of contents as a summary of the proposed strategy.

At a first glance, it looks good, with four chunky paragraphs describing the proposed approach to meet four objectives:

But the problem is that, quite frankly, the text in some of the paragraphs is not entirely intelligible. Here are a few extracts:

In this section the Regulatory Authorities objectives are reiterated as well as how the Regulatory Authorities' preferred solution can effectively achieve each objective is discussed.

Bidding principles, calling for bids to reasonable reflect marginal costs, accompanied by monitoring and the capacity payment scheme will fairly compensate generators, while preventing the exercise of sustained market power, both that which would raise prices and that which is price suppression.

While, individual plant may still have local market power, that would enable it to extract excessive constrained on payments, local market power procedures will manage this problem.

Okay, these are probably the worst of it, and the rest of the paper seems less bad — but still not up to the usual standard of drafting of UK regulatory documents.

What makes it really bad is that the above extracts are from the conclusions section, a natural place to start for readers wishing to form a quick impression of the paper. The impression that I personally formed was that the regulators still have some quality assurance issues to resolve.

Main issue: fixed-volume contracts mitigate market shares but not market power

That impression was confirmed by an examination of the substance of the strategy.

I think that my biggest objection is to the belief that imposing some restructuring contracts will remove market power from the electricity commodity market (essentially, the markets for contracts for differences against the single Irish pool price), and therefore remove the need to think about how to prevent abuses by ESB, which controls most of the generation capacity across the island.

As an aside, the paper goes on about "incumbents" and does not distinguish between NIE and ESB, despite their significant differences in size and structure: ESB's generation is in house whereas NIE's is procured under power purchase agreements contracts that, as far as I understand, leave contracted generators free to compete in the electricity wholesale market with any capacity that they do not need to commit to the NIE contract. Presumably the superficially even-handed treatment (but, I suspect, in fact unfairly discriminatory by treating different circumstances in the same way) is needed to keep some national sensitivities quiet. I am not sure this is a sensible way of developing an electricity settlement agreement — but this is a matter for another day.

Going back to the main issue, the structure of the proposed restructuring contracts is described in section 10.3 of the paper. The proposal is to direct ESB (and, it seems, NIE) to enter into fixed-quantity contracts for differences to sell a substantial share of its electricity out at a fixed price (or a maximum price) to suppliers. The contracts would be allocated between suppliers in some sort of objective way, which implies that they would be designed to be attractive to suppliers, i.e. with a price lower than the cost of building new capacity or of taking a punt on shorter-term markets.

The paper is honest about the thinking behind these contracts (this is from the summary section, one of the sentences that did not deviate too much from the English language):

The directed contracts will effectively reduce concentration to levels that are not indicative of market power.

It is true that the contracts would reduce concentration: looking at things from the short-term wholesale markets and/or the electricity retail markets, the wholesale electricity sold through the restructuring contracts would now be coming from new entrants.

I don't know what levels of concentration are "indicative of market power", but presumably these contracts could be organised to as to reduce the share of supply of ESB to something like 30 per cent, and to have quite a few independent people with high single-figure percentages: i.e. something that would look like the market share structure of a happy competitive market.

But what is not true is that reducing market shares in this way through fixed-volume contracts would reduce market power.

The regulatory authorities' paper actually comes very close to acknowledging this in its discussion on pages 49-50 of the choice between full output / share of output / "full requirements" and fixed volumes for the structure of the restructuring contracts: the regulators' basis for preferring fixed-volume contracts is that they leave ESB with "the same profit incentive it would have if there was no such contract". This is considered to be a good thing in the sense that it will maintain incentives to optimise plant availability and output.

What the paper does not advertise is that leaving ESB with the same profit incentive for its bidding and operating decisions as if there was no restructuring contract also means leaving it with the same market power (if indeed it has any to start with) to set short-term wholesale contract prices and pool prices without being subject to effective competitive constraints. The buyers of restructuring contracts will not bid into the pool, and will effectively have zero marginal costs when offering electricity from restructuring contracts on short-term wholesale markets: so they will accept whatever price is set by others and not contribute anything additional to any process of rivalry.

It seems that the volume sold through the contracts imposed on ESB would be less than ESB's expected generation output, so that there would be no probability of turning ESB into a buyer of electricity on wholesale markets.

All that the regulatory authorities' proposed contracts would do, therefore, is to redistribute the profits of generation by forcing ESB to swap a market-related income for a fixed income in respect of part of its generation output.

Presumably the idea is that this reduces ESB's incentive to cause short-term wholesale prices or pool prices to be high, because it would only receive a share of the money extracted from consumers in this way.

It may therefore be that the proposal reduces incentives to exploit market power through high prices. What it does not do is to "eliminate market power" (the claim on page 67).

This matters in two ways:

Incentives to exploit market power will continue to exist whilst some output is sold at market prices outside the contracts, even if ESB's supplies outside the contract is a small share of the wholesale market.

If the regulators wanted to eliminate all incentives to exploit market power they would need to require all output to be sold at directed prices; as it stands they seem to want to limit themselves to reducing the incentive somewhat, but there is no basis on how low an incentive is acceptable.

These contracts are, unsurprisingly, not a "miracle cure" to the issue of monopoly.

But there are other possible abuses of market power: most obviously the ability to engage in unfairly predatory conduct or price squeezes.

The regulators make some claims that they have addressed those other issues through conduct regulation (including a system involving a market monitor reporting on participants' behaviour, which sounds like a regulatory nightmare) but I have not got to the bottom of whether this is claimed to be effective on its own or whether it rests on the false conclusion that the restructuring contracts would lead to a situation where "price signals will reflect competitive forces".

And, unsurprisingly given the problems with the August document, the latest paper does not make much headway towards identifying what the exact problem is. For example, how do you decide that a particular use of market power is an abuse that ought to be mitigated?

The regulators also have still not considered how competition law applies to electricity trading (perhaps they were too busy filling in questionnaires for the European Commission's market inquiry?) and whether the mitigation proposals are to run alongside the continuation of price controls on ESB's generation and NIE's power procurement businesses.

Summary: the regulators want to appropriate market power, not mitigate it

I think that the best way of understanding the regulators' proposal is that it is an appropriation of market power, rather than a policy to mitigate it. The regulators' proposals do not seem likely to create any competitive constraints, or to prevent abuses of market power other than perhaps its exploitation through high wholesale prices.

What it really does is to transfer some the power to decide how much to exploit customers (which is to say, the market power) away from ESB and NIE (if NIE has any) towards the regulators, who will exercise it in setting prices in the restructuring contracts.

And just in case it was not clear enough that the regulators want to retain oversight over pricing even once the cross-border supposedly competitive market is in place, pages 5 and 60 confirm that:

The Regulatory Authorities retain all options with respect to profit controls after SEM implementation and make no decisions generally on the topic herein.

Key links

Entry added by Franck Latrémolière on 8 February 2006

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Last changed by Franck at 1:43 PM on Tuesday 11 April 2006.

Reference for this page:
Reckon Open "Market power in Irish electricity, part 2 | viewpoint: Franck" 2006-04-11T13:43:00