Mismeasuring Electricity Market Power

Abstract:     
By studying average variable costs, researchers examining the California energy crisis were sure to find examples of market power - even if that power may not have existed. By studying average variable costs, researchers examining the California energy crisis were sure to find examples of market power - even if that power may not have existed.

The approach taken in most empirical analyses of market power in electricity rests on a flawed application of a standard measure of market power: the fraction of a good's price exceeding its marginal production cost (known as the Lerner index or the price-cost margin). The flaw in those electricity market studies is not that the price-cost margin is theoretically inappropriate, but that it is inappropriately implemented. The proxy for "marginal cost" used to estimate price-cost margins is typically the average variable or operating cost of the last generator that would be dispatched to meet energy demand. The need to recover fixed costs can lead to prices substantially above average variable costs in peak periods. Real-world "noise" in the form of uncertainty regarding demand and supply shocks (e.g., unanticipated hot weather, generator outages) could lead to patterns of market bids that fail the average variable cost test without necessarily indicating market power.

Number of Pages in PDF File: 6

Keywords: Energy crisis, California, electricity, market power, utilities, electricity market power, energy regulations, energy market, public policy, energy policy

JEL Classification: Q4, Q41, Q48, D4

Accepted Paper Series