Market opening in energy network industries: natural monopolies and costs

Energy Economics: Market Opening in Energy Network Industries

Learning Objectives

• Distinguish different types of efficiency (allocative and productive)
• Understand the theoretical and contextual arguments behind liberalization
• Know about the European framework for liberalization
• Know the organization of unbundled network industries
• Liberalization vs privatization
• Apply critical thinking to liberalization and restructuring

Market Competition in Electricity Systems

1. Why did we open electricity systems to market competition?
2. The case of natural Monopolies
3. A brief history of electricity systems
4. 4 EU Directives for market opening in electricity
5. Where are we now?

Electricity System Components

Color Key: Red: Generation Blue: Transmission Green: Distribution Black: Customer Substation Step Down Transformer Subtransmission Customer 26kV and 69kV Transmission lines 765, 500, 345, 230, and 138 kV Generating Station Primary Customer 13kV and 4kV Source: US DOE Generating Step Up Transformer Transmission Customer 138kV or 230kV Secondary Customer 120V and 240V

Economic Background for Free Competition

Competitive markets allow market players (buyers and sellers) to freely express how they value a good in setting the price. - For the buyer this price should at least cover its marginal production cost - For the seller, the price should be lower than the marginal utility he receives from consuming the good (expressed through his willingness to pay) Competitive forces theoretically ensure that this mechanism of free decision to produce/sell and free decision to buy will reach the highest Welfare at the society level.

Utility Maximization

Utility maximization: Consumers maximize the utility they derive from the consumption of goods, services and leisure.

Utility definition: "Utility is a term in economics that refers to the total satisfaction received from consuming a good or service. Economic theories based on rational choice usually assume that consumers will strive to maximize their utility. The economic utility of a good or service is important to understand, because it directly influences the demand, and therefore price, of that good or service."

Profit Maximization

Profit maximization: Producers choose an output level so as to maximize the profit they obtain from selling goods or services.

Assumptions: · Producers behave rationally, are fully informed and take the market price as given. They act as price takers. · There are plenty of producers/suppliers. No market power. · Homogeneous products (no quality/brand distinction, etc.) · Suppliers incur costs for the production of a good. · Short-term perspective (no investments); profit maximization is for an unspecified time interval (e.g., a year) Địa lo Check Lecture 1 and 2

Conditions of Perfect Competition

What are the 5 conditions of perfect competition? · Market atomicity (large numbers of buyers and sellers in the market for liquid markets) · Free entry and exit of firms in the market. . Each firm should be selling a homogeneous product. · Perfect information (Buyers and sellers should possess complete knowledge of the price and quantities traded on the market). · No price control.

Can you think of reasons that would explain imperfect competition?

Evolution of Electricity and Gas Sectors

How we passed from a fully monopolistic situation in the electricity (and gas) sector to markets . Since the mid 90s, the electricity & gas sectors went through profound transformations, from monopolistic, integrated State-owned companies, to unbundled, open to competition, and trans-national companies. · The main goal of this opening was to eliminate monopolies and introduce competition on the production and sale of energy. · Wholesale and retail markets were introduced throughout the 2000s which are still going through further developments . But part of the industry remained in a situation of a natural monopoly

Spot Market Dynamics

Spot market Day-ahead spot market is the market of the commodity for today, right now. . Separation and confrontation of offer and demand nordpool · S-D dispatch based on merit order PCR . Transparency in price setting (prices reflect market conditions and vary on an hourly basis), and prices are published every day by the TSOS . Easier free and non-discriminatory entry into the market by new players . Increased security of supply (more accurate price signals for scarcity) omie GME

Sequence of Financial and Physical Markets

Sequence of financial and physical markets Financial markets Transactions between market participants sellers and buyers) Derivative markets Day-ahead market Intraday market Physical operation Reserve procurement, interconnection capacity allocation A.S. Tertiary, secondary primary Imbalance sattement Transactions between market participants and TSO ypat ahead Months D-1 Gate closure H-1 Real time Time * A.S. : ancillary services Check Lecture 5

Economic Background for Free Competition (2/2)

Some quick basic recap: Economic background for free competition (2/2) Highest Welfare = Max productive efficiency + Max allocative efficiency

Productive Efficiency

Productive efficiency Means for a company to produce as much as possible and as cheap as possible, considering all the available resources. MIN Cost and MAX Quantity What elements do we include in production cost? How can we increase productive efficiency?

Allocative Efficiency

Allocative efficiency Refers to how limited resources are shared between different uses bringing different benefits (values). When the price is set at the level that maximizes the number of consumers that can access the good. e.g. Biomass cascading principle: aims at using biomass like wood or agricultural products according to its highest economic and environmental value. Wood of good quality should not be burnt for electricity generation, but be used for construction, etc ...

The Special Case of Natural Monopolies

Monopoly Formation

How Monopolies Come into Existence ... . Lower production cost than competitors, e.g., economies of scale in production (natural monopoly) - Horizontal or vertical mergers or takeovers - Acquisition of control over key input (either direct input or essential facility, such as electricity networks, gas pipelines, wires ... ) - High barriers to entry (very high fixed costs) . Government granted or legally created monopolies: patents on products Lecture 2: 9

Definition of Natural Monopoly

Definition: natural monopoly 1. An industry with Economies of scale & increasing returns: The more the quantity produced and the larger the firm and production factors, the lower the average cost per unit. 2. High Fixed Costs, low Marginal Costs: Industries with high initial infrastructure or fixed costs and relatively low marginal costs often lead to natural monopolies. Once the infrastructure is established, the cost of producing additional units is minimal. 3. Economies of scope: cost advantages that a firm can achieve by producing a variety of goods or services rather than specializing in the production of a single product. It is achieved by sharing resources, such as raw materials, equipment, labor, or expertise across different products. 4. Single Dominant Firm: A single firm can satisfy the entire demand at the lowest possible cost. 5. Public Interest Concerns: Due to the lack of competition, natural monopolies are often subject to government regulation to ensure fair pricing, quality of service, and accessibility to all consumers.

Examples of Natural Monopoly Companies

What natural monopoly companies do you know?

Network Industry Definition

Definition: Network industry Network Industries refer to those economic sectors whose products or services are delivered to the final customers via 'a network infrastructure'. 8 industries are considered as Network Industries: telecommunications, postal services, energy (electricity and natural gas), transport (urban, air and railways) and water. The goods and services provided by these Network Industries have a strategic role within the economy, as they consist of the prime public utilities that are essential inputs for other sectors. A network industry is a natural monopoly. It carries the same characteristics + the following ones: Brings network positive externality, aka "network effect". It Occurs when the value of a good or service increases for an individual as more people use it. This creates a Positive Feedback Loop: The more users a network has, the more attractive and useful it becomes, which encourages even more users to join. Cost subadditivity principle: Leading to a Single Dominant Firm, meaning that it is cheaper for 1 firm to deliver the good or service than it would be for 2 or more. Competition would result in duplication and wasteful use of resources and higher prices. C(q1 + q2) < C(q1 ) + C(q2) Note that negative externalities may also arise in network industries: When the level of utility (satisfaction) of consumers decreases when the number of users increases

Gas Power Plant vs. Transmission Grid

Intuitive example: Let's compare a gas power plant and a transmission grid Fixed Cost Variable Cost FC VC

Transmission and Distribution Grids

Definitions Transmission grids Distribution grids Voltage level High > 110 KV Medium and low <33kV Operator Transmission system operation (TSO) Distribution system operation (DSO) Architecture Meshed Radial Governance Regulated Regulated Scale Large / transnational Local Architecture Meshed Radial Both systems operate as stand alone, but the increase of decentralized renewables connected to the distribution grid promotes a better coupling between the two.

A Brief History of Electricity Systems

Key Periods in Electricity System Development

1879- From the lab to the streets. A market yet to be found 1900-electricity enters our homes Local systems 1920 - 90s: The time of centralisation Use of AC for transmission over long distances Interconnection across countries Development of large generation plants