Severin Borenstein and James Bushnell (UCEI)
In PWP-044, Borenstein and Bushnell use a market simulation approach to examine the potential for market power in a restructured California electricity market. They use historical data on plant costs and capacities to simulate a deregulated market for electricity in California following restructuring. While it is important to recognize the limits of a static competitive model such as ours, this approach still provides useful insight into the workings of markets and the factors that may have the greatest influence on the exercise of market power. Their model indicates that, under the current structure of generation ownership, there is potential for significant market power in high demand hours. The most severe problems arise in the fall and early winter months when hydroelectric output is at its lowest level relative to demand in both California and the pacific northwest.
The simulation results also show that two of the most important factors in determining the extent and severity of market power are the levels of available hydroelectric production and the elasticity of demand. In fact, these factors have a greater impact on equilibrium prices than the proposed divestitures of California's largest producers. The equilibrium price during the peak hour of September is cut in half when PG&E divests half of its gas units to one firm and SCE divests all of its gas units to two firms (assuming average hydroelectric availability). However, when demand elasticity is increased from the current short-run estimates, 0.1, to a greater but still fairly inelastic level of 0.4, the peak price in this hour is one-tenth its original price, even with PG&E and SCE retaining ownership of all their current units. It is important for policy makers to recognize that elasticities of both supply and demand are not completely exogenous factors. These results indicate that policies that promote the responsiveness of both consumers and producers of electricity to short-run price fluctuations can have a significant effect on reducing the market power problem. Such policies may be more rewarding, and face less resistance, than remedies that rely on structural changes to the industry or direct intervention in price setting.