The Price Surge in the Japanese Wholesale Electricity Market in January and the Lessons for Market Design

From late December 2020 through mid-January 2021, an upsurge in wholesale electricity prices attracted wide media coverage. Until then, the price of electricity traded at Japan Electric Power exchange had mostly stayed at less than 10 yen per kilowatt hour (kWh). Even during the peak hours in summertime, the price usually peaks at around 50 yen/kWh. However, starting in late December, the price rose and stayed higher than 200 yen/kWh for several consecutive hours, temporarily climbing to as high as 251 yen/kWh (Figure 1).

Source: Electricity and Gas Market Surveillance Commission, "Trend in the Spot Market Price" (February 5, 2021)

For readers who are not directly involved with the electricity market, the idea of trading electricity in a market may sound unfamiliar. Therefore, when considering why the price surged and how to improve the situation, it is necessary to understand how electricity market trading works and the difference between the market pricing system and the traditional "rate-of-return regulation". This paper attempts to explain the basics of the electricity market and outline the points that have become clear in recent years as a result of research in the study of energy economics, including my research.

Before electricity liberalization reform, regional monopolies generated and sold electricity directly to users (retail sales), with a single electric power company operating as the exclusive supplier in each region. As a result, electricity prices were fixed through negotiations between the regional monopolies and the regulatory authorities, rather than being determined by the market. The pricing system used under this arrangement is the "rate-of-return regulation" system. Under this system, electric power companies report the cost of power generation to the regulatory authorities and earn revenue based on prices corresponding to the cost plus a margin.

What is important from the viewpoint of economics is that under the rate-of-return regulation, the "principle of proportionality between the price and the average cost" is the foundation of electricity pricing. For example, when a regional monopoly operates various types of power stations, including nuclear, hydroelectric, fossil-fuel thermal and wind power stations, the "average cost" of all those power stations affects its electricity price.

There are at least three problems with the rate-of-return regulation. First, because of a lack of competition, there is no incentive for electric power companies to improve their business efficiency by holding down costs. Second, outsiders know little about the status of electric power companies' costs and equity capital relative to the information possessed by the companies themselves, which means the presence of an information asymmetry between the companies and the regulatory authorities. As a result, it is difficult for the regulatory authorities to minimize the power generation cost through surveillance and regulatory activities. Third, from the viewpoint of maximizing social welfare as defined by economics, the principle of proportionality between the price and the average cost is undesirable because it does not minimize society-wide costs (Note 1).

As a solution to those problems, reforms of electricity systems have been implemented since the 1990s around the world. The reforms centered on the "separation of electric power generation and supply"—which enables fair access to power grids by separating power generating and transmitting/distributing operations—and the introduction of a "wholesale electricity market." This paper focuses on the wholesale electricity market. For explanations about the separation of electric power generating and transmitting/distributing operations, please refer to other papers I have written (Ito 2020a, and Ito 2020b).

Usually, a wholesale market is divided into a futures market, where contracts for delivery on a future date are traded, and a day-ahead market, where contracts for next-day delivery are traded, and a real-time market, where contracts for same-day delivery are traded (Note 2).

As a general rule, in the day-ahead and real-time markets, electricity is traded through auction. Power stations, which are sellers, submit offered volume and prices, while buyers submit bid volume and prices. As shown in Figure 2, offered prices form a stair-like line, a supply curve representing a full range of offers, representing offers from high-cost to low-cost power sources. Bid prices form a demand curve representing a full range of bids, from bids from buyers willing to pay a high price to bargain-hunting buyers. The market price is determined where the supply and demand curves intersect (Note 3). In the electricity market, the principle of market pricing works in a textbook manner.

What is important here is that in contrast to the rate-of-return regulation, pricing in the wholesale electricity market is based on the "principle of proportionality between the price and the marginal cost." For example, even when a seller operates various types of power stations, including nuclear hydroelectric, fossil-fuel thermal and wind power stations, the "marginal cost," located at the intersection of the supply and demand curves, rather than the "average cost," is the determinant pricing factor (Note 4).

Source: Prepared by the author. The market price is determined where the supply and demand curves intersect.

The advantage of an auction system is that it resolves the abovementioned problems inherent in the rate-of-return regulation. A company generating power at high cost due to poor efficiency may be able to continue generating power under the rate-of-return regulation. However, in an auction market, it is impossible to sell electricity if the power generation cost is higher than the market equilibrium price. The information asymmetry regarding the power generation cost can be resolved by the invisible hand of the market, rather than by surveillance by the regulatory authorities.

The above arguments represent nothing more than theoretical forecasts based on theories of economics. In the real world, did the electricity liberalization centering on the separation of electric power generation and supply and the introduction of a wholesale market lead to a lower power generation cost? In the field of economics, a significant amount of empirical research has been done in order to answer this question over the past two decades. On the whole, research done in various countries have found that electricity liberalization leads to a lower "power generation cost." For example, a research group including Professors Nancy Rose (the Massachusetts Institute of Technology), Catherine Wolfram (UC Berkeley), and Kira Fabrizio (Boston University) showed that if the rate-of-return regulation is abolished in the power generation sector following the separation of power generation and supply and if free competition is introduced through wholesale market trading, the production efficiency of power stations improves, leading to a lower power generation cost (Fabrizio, Rose, and Wolfram. 2007).

Professor Steve Cicala (Tufts University) analyzed hourly data on power generation and cost at power stations across the United States and showed that electricity trading in a wholesale market following the separation of power generation and supply leads to a lower society-wide power generation cost as it reduces generated volume at high-cost power stations while increasing generated volume at low-cost ones (Cicala, forthcoming). Both of the above research findings, which were published in the international journal American Economic Review, represent the results of the careful analysis of causal relationships.

From the above, can we definitively say that electricity liberalization leads to a lower "electricity price" as well as a lower power generation cost? It should be kept in mind that when electricity liberalization is discussed in newspapers and other media, the impacts on cost and price are confused with each other in many cases. When we consider the impact on the electricity price, it is important to understand the following three points based on the basics of microeconomics.

The first important point is that electricity liberalization brings about a paradigm shift from the principle of proportionality between the price and the average cost to the principle of proportionality between the price and the marginal cost. From the viewpoint of welfare economics, the principle of proportionality between the price and the marginal cost can be said to be superior in improving market efficiency after liberalization. However, maximization of social welfare does not necessarily come with price minimization. Whether liberalization lowers or raises the price depends on the relationship between the average and marginal costs of power sources in regions where it is implemented.

In other words, if liberalization is implemented in regions where the average cost is higher than the marginal cost, a price drop is more likely than a price increase. If liberalization is implemented in regions where the average cost is lower than the marginal cost, a price increase is more likely. Therefore, the argument that electricity liberalization always leads to a price drop is wrong, as is the argument that it always results in a price increase.

The second important point is that the key determinant pricing factor after liberalization is the marginal cost of the "marginal power source." For example, in Figure 2, natural gas-fired thermal power is the marginal power source (whose electricity price is located at the intersection of the supply and demand curves). This means that fluctuations in the natural gas price directly affect the electricity price. On the other hand, pricing before liberalization is based on the average cost of all power sources, which means that fluctuations in the costs not only of a single particular power source but of all power sources affect the electricity price.

The third important point is that a wholesale market is not perfect in itself but should be accompanied by measures to resolve market failures. The most important of the market failures that could occur in a wholesale electricity market is the exercise of market power by a major electric power company. An electric power company with a market share large enough to influence the electricity price has an incentive to raise the price by reducing supply volume when the supply-demand balance is tight. The reason why the exercise of market power is an issue in an electricity market in particular is that the supply curve forms a steep upward slope—the slope may become even vertical in an extreme case—as the demand volume gets closer to the peak (Figure 3). That is because the marginal cost is high for peak-load power sources (power stations which are started up at the peak demand time) and also because the supply curve ends at the point where sell offers disappear.

In the situation indicated by Figure 3, a company with a monopoly can boost profits by raising the price through the reduction of sales volume. For people who are not familiar with the study of economics, the idea that the reduction of sales volume leads to a profit increase may not be intuitively comprehensible. This phenomenon occurs because even a small reduction of supply may cause a very steep price increase when the supply curve forms a steep upward or vertical slope.

Real-world data shows that monopoly companies behave in the textbook monopolistic manner, and such behavior has been confirmed by many empirical works, including my research (Note 5). Therefore, it is necessary to carefully watch whether or not companies with dominant market power are deliberately reducing sales around the peak demand time. In wholesale electricity markets in various countries, a wide variety of measures are used to prevent the exercise of market power.

Source: Prepared by the author. When the market price is determined along a vertical portion of the supply curve, a steep decrease in sell offers tends to result in a price surge. While a steep decrease in sell offers may occur as a result of deliberate price manipulation, it may also be caused unintentionally by other factors, such as a fuel shortage and power station maintenance work.

One thing to remember is that it is simplistic to conclude, on the evidence of the recent price surge, that the market is not functioning. In fact, the market price has stayed at a very low level except during the period of the price surge, which means that buyers have been able to purchase electricity at low price, and power stations must have made efforts to reduce their costs.

Even so, as the wholesale price surge that started toward the end of 2020 was unusual in terms of both its steepness and duration, it is essential to identify the cause. In this respect, investigations led by the regulatory authorities and market participants are still ongoing. In addition, the Task Force for Comprehensive Review of Laws and Regulations for Renewable Energy and Other Resources, led by Minister of State for Regulatory Reform Kono, conducted an independent investigation and announced a set of urgent recommendations related to the electricity price surge.

This problem has been further complicated by the near-impossibility of conducting a data-based analysis due to a lack of progress in data disclosure regarding the electricity market. Regardless of this difficulty, below, I will discuss what lessons can be learned from the wholesale price surge that started toward the end of 2020 in light of the limited amount of disclosed data and the mechanism of the wholesale electricity market that I explained in this paper.

First, as far as can be surmised from the disclosed data, the main cause of the price surge is likely to be a decrease in sell offers in the market. Of course, an increase in demand due to cold waves was also an influencing factor. However, the data shows that even when demand was high, the presence of a price surge was dependent on the time slots. Therefore, it is difficult to conclude that a demand increase is the main influencing factor. On the other hand, it was always during a price surge that that sell offers steeply decreased. The situation was exactly the same as that indicated by Figure 3. In other words, as the market price was determined along a vertical portion of the supply curve, a decrease in sell offers became a significant price-influencing factor.

What measures can be taken to prevent this situation in the future?

The first option is to promote competition among electric power suppliers. In Japan's electricity market, a handful of major electric power companies (former general electric utilities) still account for around 80% of overall sell offers (offers from power stations) in the wholesale market. In other words, this is an oligopolistic market dominated by a small group of sellers. In an oligopolistic market, the behavior of the handful of companies with large shares significantly affects price determination at the peak demand time. This situation occurs regardless of the presence or absence of a malicious intent to manipulate market price. This point is clear from data analyses conducted in recent years, including my research (Ito and Reguant, 2016).

For example, if a major electric power company curbs supply to the wholesale market (placing the priority on providing a sufficient volume of electricity to its retail sales division) when demand spikes, the price surges due to a sharp decrease in sell offers in the market. If the oligopoly of major electric power companies maintaining substantial retail sales operations continues, the risk is high that the market price may become unstable when demand spikes.

As a measure to prevent that kind of situation, under the reforms of electricity systems in other countries, for example, major electric power companies were required to sell the whole or parts of their power generation divisions to other companies during the establishment of a wholesale market. Measures like this were implemented based on laws and regulations in order to prevent oligopolistic and monopolistic behavior.

The second lesson is the need for data disclosure. In foreign electricity markets, information is disclosed with respect to the power generation volume and the value and volume of sell offers per power station and the value and volume of bids per bidder company on an hourly basis. Disclosure of such information helps to secure the integrity and transparency of the market and facilitates the smooth functioning of the market. Compared with the situation in foreign markets, information disclosure regarding Japan's electricity market is lagging considerably, and therefore, it is difficult to identify the causes of incidents like the recent price upsurge.

In this respect, on January 22, disclosure of the supply and demand curves started, albeit on a limited basis. Although it is impossible to identify a causal relationship from Figure 1 alone, this information disclosure may have produced some positive benefits given that a price surge has not occurred since the start of disclosure on January 22.

The third lesson is that the market principle that the electricity price is strongly affected by the auction behavior of marginal power sources has major significance for market participants and the regulatory authorities. In particular, marginal power sources (also known as peak-load power sources), namely power stations that are only used when demand hits peaks in summer and winter, are of utmost importance because they become a very significant price-influencing factor at the peak demand time. It should have been possible to foresee that LNG-fired thermal power stations would serve as marginal power sources toward the end of last year. It is worth examining what precautionary measures were taken by the regulatory authorities and participants in the electricity market to ensure stable LNG procurement.

The fourth lesson is that if gas-fired thermal power stations are likely to continue serving as marginal power sources, it is necessary to make efforts to keep their power generation cost stable. Unlike the United States, Japan does not have domestic shale gas resources or gas pipelines. As a result, unless a sufficient quantity of storage facilities and a method of stable LNG procurement become available, Japan will be unable to prevent similar effects from the kind of demand surge that occurred recently.

In relation to this point, in the United States, there is an ongoing introduction of a dual-fuel thermal power generation technology, which enables gas-fired thermal power stations to use oil. In late 2020, the oil price was low because of a decline in worldwide oil demand caused by the COVID-19 crisis. Therefore, if many gas-fired power stations in Japan had been equipped with the dual-fuel technology, it might have been possible to prevent the electricity price surge.

The fifth lesson is that a mechanism to ensure price stability should be introduced to the wholesale spot market. For example, in other countries around the world, policy measures are underway to curb the volatility of the wholesale electricity spot market by introducing various sorts of futures trading and promoting an increase in long-term, bilateral, negotiated contracts. If long-term, bilateral negotiated contracts are available as a trading option, companies focusing exclusively on retail sales can secure electricity without relying on wholesale-market spot contracts alone. As a result, it is possible to prevent the spot price from being affected by disruptive behavior on the part of buyers.

As explained above, while the market system brings various benefits, it is in no way perfect. Designing an electricity market is particularly difficult. Therefore, it is always necessary to conduct careful data-based analysis and to develop a better market design based on scientific analysis. For more detailed discussion on the design of an electricity market, please refer to Ito (2020b).

The original text in Japanese was posted on March 9, 2021.