Policy Evaluation for Oligopolistic Markets - A Case of Wholesale Electricity Market -

Author Name HASUIKE Katsuhito  (Chief Consultant, Nomura Research Institute) /KANEMOTO Yoshitsugu  (Faculty Fellow)
Creation Date/NO. July 2005 05-J-024
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Countries that are forerunners in electricity market liberalization have encountered the problem of how to deal with market power of electricity suppliers. How to ensure competition in the electricity market is a crucial question facing Japan, which has started the liberalization process recently. This paper aims to expound an evaluation method that measures the degree of competition in an electricity market by utilizing a simulation model.

As a hypothetical case, we assumed a duopoly market dominated by two electricity companies, whereby we created two simulation models with two extreme settings of competition, namely the Bertrand and Cournot models, each of which shows the resulting wholesale electricity price in the oligopolistic market in one hour during the summer peak time. First, we calculated the efficient solution (i.e. the Bertrand equilibrium price or the market price under perfect competition equilibrium) that is realized in a situation where each company takes the price set by its rival as given. Then, we compared this with the price under the Cournot equilibrium. We found that the Cournot equilibrium price is roughly six times higher than the Bertrand equilibrium price, resulting in the deadweight loss of 629 million yen per hour.

As a way to mitigate market power under the Cournot setting, we assumed three policy options: 1) introducing long-term contracts, 2) allowing "fringe players" (non-established power suppliers) to enter into the market, and 3) splitting up the established power companies. Then, we evaluated the effect of each of these policy options through numerical simulations.

With respect to the first policy, under which established power producers would hold long-term contracts with retailers, we found that the greater the portion of long-term contracts held by the producers the lesser their market power. When the proportion of long-term contracts increases to 30%, 60% and 90%, the wholesale market price of electricity decreases to 33.3 yen/kWh, 21.2 yen/kWh and 11.0 yen/kWh respectively, compared to 47.0 yen/kWh when the companies hold no long-term contract. The social surplus increases with the rise in the proportion of long-term contracts, up by 358 million yen, 545 million yen and 625 million yen from the level under the Cournot equilibrium when long-term contracts account for 30%, 60% and 90% respectively. That is, when the proportion of long-term contracts reaches 90%, the resulting social surplus is almost same as the one obtained as the efficiency solution.

The effect of the second policy -- allowing fringe players to enter the market --differs depending on the scale of their presence and marginal costs involved. However, in order to realize an increase in the social surplus equivalent to the efficiency solution, fringe players' combined power-generating capacity must reach a level where they can together cover roughly half the total electricity demand.

As to the third policy, we found that splitting the larger of the two power generators into two separate companies results in a social net benefit of 384 million yen, generating an effect equivalent to the one achieved by increasing the proportion of long-term contracts to 30%.

The conclusions described above are based on a simple hypothetical case and not on an evaluation of the actual electricity market. However, we believe that the approach we have taken can be developed into an effective method for evaluating the degree of competition in the electricity market if we expand the simulation models thereby creating a situation closer to reality.