Showing papers in "Journal of Regulatory Economics in 2011"

Demand response in wholesale electricity markets: the choice of customer baseline

Abstract: Given a hybrid electricity market structure, demand response (DR) in wholesale electricity markets depends critically on the choice of customer baseline. This paper reviews alternative customer baseline designs, focusing on administrative and contractual approaches. Administrative customer baselines have been developed over many years to provide estimates of the counterfactual consumption levels that would have prevailed without demand-response programs. However, experience suggests that this approach is vulnerable to opportunities for gaming and could result in illusory demand reductions. With full locational marginal price (LMP) payment, this approach imputes double-payment incentives that could induce excessive demand reduction undermining the efficiency of DR programs. Alternatively, a contractual customer baseline approach provides transparent rights and obligations for a robust framework that restores efficient DR under full LMP payment. As a retail rate design that provides two-sided contractual customer baselines, demand subscription service and DR programs form a much needed connection between the wholesale and retail markets in ways that promote price-responsive demand in a smart grid future.

Price-cap regulation of congested airports

Abstract: This paper investigates price-cap regulation of an airport where the airport facility (e.g. runway) is congested and airlines have market power. We show that when airport congestion is not a major problem, single-till price-cap regulation dominates dual-till price-cap regulation with respect to optimal welfare. Furthermore, we identify situations where dual-till regulation performs better than single-till regulation when there is significant airport congestion. For instance, when the airport can cover the airport costs associated with aeronautical services simply through an efficient aeronautical charge then dual-till regulation yields higher welfare.

Dynamic pricing of electricity in the mid-Atlantic region: econometric results from the Baltimore gas and electric company experiment

Abstract: The Baltimore Gas and Electric Company (BGE) undertook a dynamic pricing experiment to test customer price responsiveness to different dynamic pricing options. The pilot ran during the summers of 2008 and 2009 and was called the Smart Energy Pricing (SEP) Pilot. In 2008, it tested two types of dynamic pricing tariffs: critical peak pricing (CPP) and peak time rebate (PTR) tariffs. About a thousand customers were randomly placed on these tariffs and some of them were paired with one of two enabling technologies, a device known as the Energy Orb and a switch for cycling central air conditioners. The usage of a randomly chosen control group of customers was also monitored during the same time period. In 2009, BGE repeated the pilot program with the same customers who participated in the 2008 pilot, but this time it only tested the PTR tariff. In this paper, we estimate a constant elasticity of substitution (CES) model on the SEP pilot’s hourly consumption, pricing and weather data. We derive substitution and daily price elasticities and predictive equations for estimating the magnitude of demand response under a variety of dynamic prices. We also test for the persistence of impacts across the two summers. In addition, we report average peak demand reduction for each of the treatment cells in the SEP pilot and compare the findings with those reported from earlier pilots. These results show conclusively that it is possible to incentivize customers to reduce their peak period loads using price signals. More importantly, these reductions do not wear off when the pricing plans are implemented over two consecutive summers. Our analyses reveal that SEP participants reduced their peak usages in the range of 18 to 33% in the first summer of the SEP pilot and continued these reductions in the second summer.

Is fixed-mobile substitution strong enough to de-regulate fixed voice telephony? Evidence from the Austrian markets

Abstract: We estimate own-price elasticities for fixed network voice telephony access and (national) calls services for private users and cross-price elasticities to mobile using time series data from 2002-2007 from the Austrian market. Using instrumental variable estimates and taking into account the possibility of cointegration we find that access is inelastic while calls are elastic. We conclude that the retail market for national calls of private users can probably be deregulated due to sufficient competitive pressure from mobile. Access-substitution on the other hand does not seem to be strong enough to justify de-regulation.

Optimal transmission switching: economic efficiency and market implications

Abstract: Traditionally, transmission assets for bulk power flow in the electric grid have been modeled as fixed assets in the short run, except during times of forced outages or maintenance. This traditional view does not permit reconfiguration of the transmission grid by the system operators to improve system performance and economic efficiency. The current push to create a smarter grid has brought to the forefront the possibility of co-optimizing generation along with the network topology by incorporating the control of transmission assets within the economic dispatch formulations. Unfortunately, even though such co-optimization improves the social welfare, it may be incompatible with prevailing market design practices since it can create winners and losers among market participants and it has unpredictable distributional consequences in the energy market and in the financial transmission rights (FTR) market. In this paper, we first provide an overview of recent research on optimal transmission switching, which demonstrates the substantial economic benefit that is possible even while satisfying standard N−1 reliability requirements. We then discuss various market implications resulting from co-optimizing the network topology with generation and we examine how transmission switching may affect locational Marginal Prices (LMPs), i.e., energy prices, and revenue adequacy in the FTR market when FTR settlements are financed by congestion revenues.

Locational-based coupling of electricity markets: Benefits from coordinating unit commitment and balancing markets

Abstract: We estimate the benefits of electricity locational marginal pricing (LMP) that arise from better coordination of day-ahead commitment decisions and real-time balancing markets in adjacent power markets when there is significant uncertainty in demand and wind forecasts. To do so, we formulate a series of stochastic models for committing and then dispatching electric generators subject to transmission limits. In the unit commitment stage, the models optimise day-ahead generation schedules under either the full set of network constraints or a simplified net transfer capacity (NTC) constraint, where the latter represents the present approach for limiting forward electricity trade in Europe. A subsequent redispatch model then creates feasible real-time schedules. Benefits of LMP arise from decreases in expected start-up and variable generation costs resulting from consistent consideration of the full set of network constraints both day-ahead and in real time. Meanwhile, coordinating adjacent balancing markets provides benefits because intermarket flows can be adjusted in real-time in response to changing conditions. To quantify these benefits, we analyse a stylised four-node network, examining the effects of varying system characteristics on the magnitude of the locational-based unit commitment benefits and the benefits of intermarket balancing. We conclude that both categories of benefits are situation dependent, such that small parameter changes can lead to large changes in expected benefits. Although both can amount to a significant percentage of operating costs, we find that the benefits of coordinating balancing markets generally exceed unit commitment benefits.

The impact of carbon cap and trade regulation on congested electricity market equilibrium

Abstract: Greenhouse gas regulation aimed at limiting the carbon emissions from the electric power industry will affect system operations and market outcomes. The impact and the efficacy of the regulatory policy depend on interactions of demand elasticity, transmission network, market structure, and strategic behavior of generators. This paper develops an equilibrium model of an oligopoly electricity market in conjunction with a cap-and-trade policy to study such interactions. We study their potential impacts on market and environmental outcomes which are demonstrated through a small network test case and a reduced WECC 225-bus model with a detailed representation of the California market. The results show that market structure and congestion can have a significant impact on the market performance and the environmental outcomes of the regulation while the interactions of such factors can lead to unintended consequences.

Appropriate contract durations in the German markets for on-line reserve capacity

Abstract: This paper explores the economic implications of different contract durations in markets for on-line (primary and secondary) reserve capacity in Germany with the crucial feature of separate markets for spot energy and reserve capacity provision. The analysis is based on an equilibrium model developed by Just and Weber (Energy Econo 30:3198–3221, 2008) for reserve markets. It reveals the implicit trade-off for the bidders and implicit interdependencies between the reserve and the spot markets. Even if the markets are not explicitly coordinated, they are interrelated through the dispatch decisions of the power plant owners. The paper concludes that the current German reserve market design is inefficient and should be improved. The results clearly show that shorter periods (with resulting lower variations in overall electricity demand) lead to more efficient dispatch and market results. Not only prices in the reserve capacity markets are expected to be lower, but also spot market prices. As these benefits can be partially reaped by owners of large generation portfolios also under longer contract durations, it discriminates against smaller generation companies and can potentially deter market participation. Further, the paper takes a broader perspective and discusses security concerns against shorter contract durations. It is shown that the opportunity costs character of the reserve market implies sufficient incentives for supplying online reserve capacity. The concerns do not appear to be predominant and it should be possible to manage them appropriately.

Social welfare issues of financial literacy and their implications for regulation

Abstract: Financial literacy has become a prominent item on the public agenda worldwide, with its relevance very much underlined by the high-profile role played by consumer finance in global credit crises from 2007 onwards. Assumptions about the level of consumers’ financial literacy frequently influence the formulation of regulatory policy, whether tacitly or explicitly and many national governments are actively engaged in financial education programs of various sorts. Indeed since at least 2003 the OECD has actively developed and encouraged such efforts. An underlying supposition of these initiatives is that more financial literacy is socially preferable to less. We examine that supposition in a formal analytic framework and demonstrate plausible conditions under which it is not true. We discuss implications of this for policy-makers and regulators alike.

Imperfect legal unbundling of monopolistic bottlenecks

Abstract: We study an industry with a monopolistic bottleneck supplying an essential input to several downstream firms. Under legal unbundling the bottleneck must be operated by a legally independent upstream firm, which may be partly or fully owned by an incumbent active in downstream markets. Access prices are regulated but the upstream firm can perform non-tariff discrimination. Under perfect legal unbundling the upstream firm maximizes only own profits; with imperfections it is biased and to some extent accounts also for the incumbent’s downstream profits. We show that increasing the incumbent’s ownership share increases total output if the upstream firm’s bias is sufficiently small, while otherwise effects are ambiguous. Stronger regulation that reduces the bias without changing ownership shares generally increases total output. We also endogenize the bias and show that it can depend non-monotonically on the ownership share.

The interaction between universal service costing and financing in the postal sector: a calibrated approach

Abstract: The financing of universal service has traditionally relied on granting the universal service provider a reserved area. Together with growing electronic substitution, current liberalization policies promoting competitive entry may put the traditional universal service at risk. Hence, there is an increased interest in estimating the cost of universal service provision. The 3rd EC Postal Directive proposes a calculation approach to separately determine the net cost of a universal service obligation and to compensate the universal service provider (USP). This paper discusses the interaction between universal service costing and financing and shows that the EC approach may result in distorted results. It also quantifies the effects based on a model calibration with Swiss data. The results show that separate costing and financing leads to a considerable under-compensation of the USP if there is a compensation fund to which every operator contributes. The USP is over-compensated if it is exempt from contributing to the fund (pay or play mechanism). The problem of under- or overcompensation can be resolved by an integrated computation of the net cost that includes the competitive effects of the financing mechanism. Such an integrated approach results in a fair compensation of the USP.

Optimal pricing and capacity choice for a public service under risk of interruption

Abstract: We develop rules for pricing and capacity choice for an interruptible service that recognize the interdependence between consumers’ perceptions of system reliability and their market behavior Consumers post ex ante demands, based on their expectations on aggregate demand Posted demands are met if ex post supply capacity is sufficient However, if supply is inadequate all ex ante demands are proportionally interrupted Consumers’ expectations of aggregate demand are assumed to be rational Under reasonable values for the consumer’s degrees of relative risk aversion and prudence, demand is decreasing in supply reliability We derive operational expressions for the optimal pricing rule and the capacity expansion rule We show that the optimal price under uncertainty consists of the optimal price under certainty plus a markup that positively depends on the degrees of relative risk aversion, relative prudence and system reliability We also show that any reliability enhancing investment—though lowering the operating surplus of the public utility—is socially desirable as long as it covers the cost of investment

Do environmental audits improve long-term compliance? Evidence from manufacturing facilities in Michigan

Abstract: Using a unique facility-level dataset from Michigan, we examine the effect of environmental auditing on manufacturing facilities’ long-term compliance with U.S. hazardous waste regulations. We also investigate the factors that affect facilities’ decisions to conduct environmental audits and whether auditing in turn affects the probability of regulatory inspections. We account for the potential endogeneity of our audit measure and the censoring of our compliance measure using a censored trivariate probit, which we estimate using simulated maximum likelihood. We find that larger facilities and those subject to more stringent regulations are more likely to audit; facilities with poor compliance records are less likely to audit. However, we find no significant long-run impact of auditing on the probability of a regulatory inspection or compliance among these Michigan manufacturing facilities.

On the sufficiency of regulatory enforcement in combating piracy

Abstract: The literature on piracy has questioned the role of regulatory enforcement in the form of monitoring in deterring piracy. This article shows that for a wide range of penalty levels the equilibrium monitoring rate is such that it is optimal for the copyright holder to prevent piracy by expanding his output beyond the monopoly output level rather than producing the monopoly output level and investing in an anticopying technology. This result holds even when the monitoring cost is “sufficiently” high relative to the cost of investing in anti-copying technology.

Life insurer efficiency and state regulation: evidence of optimal firm behavior

Abstract: Proponents of an optional federal charter for life insurers argue that the current state-based system of insurer regulation increases insurer costs and reduces their revenues and profits. This study examines the impact of multi-state regulation on life insurer cost, revenue and profit efficiency. The main findings suggest that insurer cost efficiency is inversely related to the number of states licensed and directly related to total assets, after controlling for geographic concentration, insolvency risk and other firm-specific characteristics. Further, the results support the expectation that insurer expansion into additional states is optimal in that the additional regulatory and other costs associated with operating in more states are offset by higher revenues to the extent that insurer profit efficiency is not affected. A robustness test is conducted using an indicator variable for New York licensed insurers to examine the relation between regulatory stringency and insurer efficiency. This test confirms the results, even in the presence of the more stringent regulation of New York. These findings are consistent with the expectation that any regulatory cost savings that result from an optional federal charter, or single regulator, will be passed along to insurance consumers in a competitive insurance market.

Towards equilibrium offers in unit commitment auctions with nonconvex costs

Abstract: We compare two types of uniform-price auction formats commonly used in wholesale electricity markets—centrally committed and self-committed markets. Auctions in both markets are conducted by an independent system operator that collects generator bids and determines which generators will operate and how much electricity each will produce. In centrally committed markets, generators submit two-part bids consisting of a startup cost and a variable energy cost. Self-committed markets force generators to incorporate their startup costs into a one-part energy bid. The system operator in a centrally committed system ensures that each generator recovers the startup and energy costs stated in its two-part bid, while no such guarantees are made in self-committed markets. The energy cost ranking and incentive properties of these market designs remains an open question. While the system operator can determine the most efficient dispatch with a centralized market, the auction mechanism used to solicit generator data compels generators to overstate costs. Self commitment might involve less efficient dispatch but have better incentive properties. We derive Nash equilibria for both market designs in a symmetric duopoly setting. We also derive simple conditions under which the two market designs will be expected cost-equivalent.

Response of industrial customers to hourly pricing in Ontario’s deregulated electricity market

Abstract: This paper uses hourly data from Ontario (Canada) between 2005 and 2008 to estimate the effects of real time wholesale electricity prices on demand by industrial customers. Nonlinear SUR estimates from Generalized Leontief (GL) specifications reveal elasticities of substitution from 0.02 to 0.07, confirming that industrial customers (connected to the transmission grid) shift consumption across peak and off-peak periods in order to reap benefits of lower prices. Estimates from FGLS and IV models suggest that this reduction in demand by industrial customers results in lower wholesale prices, which benefits all consumers. The policy lesson is that market based schemes that encourage Real Time Pricing (RTP) pricing should result in positive spillovers to all consumers.

Quality upgrades and bypass under mandatory access

Abstract: We analyze the interaction between the incumbent’s incentive to upgrade the quality of its network and the entrant’s incentive to build a bypass network when the regulator sets a two-part access tariff to the incumbent’s network. Under this context, the entrant’s investment in a bypass network is delayed with a higher incumbent’s investment in quality. Moreover, the possibility of investment in a bypass network by the entrant has a positive effect on the incumbent’s incentive to upgrade quality. We show that a regulator cannot achieve the first best with a constant access tariff. If he wants to design an alternative welfare improving access tariff, he should set an access fee increasing (decreasing) in quality if the business-stealing effect of quality upgrades is weak (strong). The analysis suggests that if the entrant’s investment costs are declining or its market share is increasing over time, it is not always optimal to require the incumbent to lease facilities at cost-based prices.

A dynamic perspective on minimum quality standards under Cournot competition

Abstract: Imposing a minimum quality standard (MQS) is conventionally regarded as harmful if firms compete in quantities. This, however, ignores its possible dynamic effects. We show that an MQS can hinder collusion, resulting in dynamic welfare gains that reduce and may outweigh the static losses which are caused by regulation’s distortive effect on equilibrium qualities.

The design of voluntary agreements in oligopolistic markets

Abstract: This paper analyses the conditions under which a group of firms have the incentive to sign a voluntary agreement (VA) to control polluting emissions even in the presence of free-riding by other firms in the industry. We consider a policy framework in which firms in a given industry decide whether or not to sign a VA proposed by an environmental regulator. We identify the features that a VA should possess in order to provide firms with an incentive to participate in the VA and to enhance its economic and environmental effectiveness. Under very general conditions on the shape of the demand schedule, we obtain the following results. First, a VA does not belong to the equilibrium of the coalition game when benefits from voluntary emission abatement are a pure public good, unless an industry emission target is set by the regulator. Second, in the presence of partial spillovers—i.e. when signatories obtain more benefits from the VA than non-signatories—a VA can belong to the equilibrium only if a minimum participation rule is guaranteed. Third, a VA with a minimum participation rule and a minimum mandatory emission abatement may improve welfare (and even industry profits) compared to a VA in which firms are free to set their own profit maximizing abatement level.

Enforcement and Environmental Quality in a Decentralized Emission Trading System

Abstract: Should the powers of monitoring compliance and allocating tradeable emissions allowances be appointed to a unique supranational regulator or decentralized to several local regulators? To answer this question, we develop a two stage-two country game where environmental regulators set the amount of emission allowances and the level of monitoring effort to achieve full compliance while the regulated firms choose actual emissions and the number of permits to be held. Various, possibly conflicting, spillovers between countries arise in a decentralized setting. We show that decentralization is socially harmful if no asymmetry among institutional settings is introduced and can be suboptimal even when decentralization features lower monitoring costs than a centralized setting. Lower monitoring costs are therefore necessary, but not sufficient, to justify decentralization. Also, our analysis reveals that welfare can be higher under decentralization even if the corresponding environmental quality is worse than under centralization. Indeed, better environmental quality is sufficient but not necessary for higher welfare under decentralization. Finally, we discuss how these results can provide a theoretical rationale for the recent evolution of the EU ETS design.

Fixed-to-mobile call substitution and telephony market definition in Korea

Abstract: An appropriate market definition is critical in most antitrust cases. In practice, antitrust authorities define economic markets in a deterministic manner with little concern about the risk involved in defining markets incorrectly. In contrast, this article proposes a probabilistic market definition method by which antitrust authorities can establish a statistical confidence level for their intended market-definition judgments. As an application, we examine the likelihood that the fixed-line and mobile telephony services in Korea can compete in the same economic market. Combining critical loss analysis with a hierarchical Bayes model for stated preference data, we find some evidence for the separation of the fixed-line and mobile telephony markets in present-day Korea. After discussing certain possible regulation biases for market definition, we predict that the two markets will converge in the near future as the mobile price premium continues to decrease.

New approach to estimating the cost of common equity capital for public utilities

Abstract: The regulatory process for setting public utilities’ allowed rate of return on common equity has generally used the Gordon DCF, CAPM and Risk Premium specifications to estimate the cost of common equity. Despite the widely known problems with these models, there has been little movement to adopt more recently developed asset pricing models to provide additional evidence for estimating the cost of capital. This paper presents, validates empirically and applies a general yet simple consumption-based asset pricing specification to model the risk-return relationship for stocks and estimate the cost of common equity for public utilities. The model is not necessarily superior to other models in its practical results, yet these results do indicate that it should be used to provide additional estimates of the cost of common equity. Additionally, the model raises doubts as to whether assets such as utility stocks are a consumption (business cycle) hedge.

Modeling welfare loss asymmetries arising from uncertainty in the regulatory cost of finance

Abstract: The allowed rate of return (AROR) is a critical input in the regulatory assessment of revenue requirements, price caps and other controls. Errors in estimating AROR impact on investment incentives and price setting and hence can induce welfare loss. It is often suggested that the welfare losses that arise from under-estimation of the AROR may be significantly greater than arise from over-estimation. However, to date, this proposition has not been examined in any detail. This paper assesses the extent of welfare loss asymmetry and its implications for the choice of AROR.

The effect of output specification on the optimal policy design for electric utilities

Abstract: We show that the manner in which the production process is seen when analyzing data on electricity production has an impact on the policy conclusions. In particular, we show that the different specifications of output found in the literature can generate quite diverse views regarding regulation and optimal industry structure, even when using the same data to estimate a cost function. To illustrate this we use information gathered from the Spanish Electric Industry and analyze electricity activities following three approaches: the traditional aggregate activity view, the multistage model and the multioutput-multistage approach. We estimate the degree of economies of scale S and derive marginal costs for all models, plus economies of vertical integration (EVI) for the last two ones. Then we compare these results and verify that the aggregate analysis can mislead policymaking.

License scheme: An optimal waste management policy under asymmetric information

Abstract: A system requiring a waste management license from an enforcement agency has been introduced in many countries. A license system is usually coupled with fines, a manifest, and a disposal tax. However, these policy devices have not been integrated into an optimal policy. In this paper we derive an optimal waste management policy by using those policy devices. Waste management policies are met with three difficult problems: asymmetric information, the heterogeneity of waste management firms, and non-compliance by waste management firms and waste disposers. The optimal policy in this paper overcomes all three problems.

Strategic manipulation of a pollution permit market and international trade

Abstract: We consider a framework where firms which compete in an international product market are not all submitted to a pollution permit market. Using the Brander and Spencer’s framework (J Int Econ 18:83–100, 1985), we seek to determine the optimal strategies of both a dominant firm in the pollution permit market and the regulator in a such context. We first show that the dominant firm pursues a strategic manipulation to increase its profit. We also find that the regulator uses a sophisticated strategic policy to increase the domestic welfare by using two instruments: the initial allocation of pollution permits and the pollution cap.

Portfolio risk management and carbon emissions valuation in electric power

Abstract: The context is an electric power company with regulated load obligations and a spot market for energy sales and purchases, as well as liabilities incurred by carbon emissions from generation units or power contracts controlled by the company. Against the backdrop of the existing carbon cap and trade system in the European Union, this paper develops a framework for integrating energy portfolio risk management with liabilities associated with the company’s carbon emissions. The multi-period VaR-constrained portfolio approach of Kleindorfer and Li (Energy J 26(1): 1–26, 2005) is first extended to cover the implied liabilities arising from carbon emissions. This entails some changes to account for the fact that dispatch/bidding/execution decisions will be affected by carbon liabilities for some generation units and contracts. The paper then develops a dynamic programming framework for optimizing the timing of carbon trades (i.e., the timing of the acquisition of the required carbon certificates to cover carbon emissions liabilities of the company), given banked credits or allocations of carbon credits at the start of the planning period and the emissions liabilities resulting from the company’s joint energy and carbon portfolio optimization problem.