Unit 8: Market power and generators bidding

--Dr. P.S. KULKARNI

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 Syllabus:
Market power and generators bidding:
Attributes of a perfectly competitive market, the
firm's supply decision under perfect
competition, imperfect competition, market
power, financial markets associated with
electricity markets, introduction to optimal
bidding by a generator company, optimal
bidding methods.

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Attributes of a perfectly competitive market

In a perfectly competitive market, all the market participants choose the level of their output
such that their marginal cost is equal to the market price, which makes the market settle at an
equilibrium that is optimal for the social welfare.
A perfectly competitive market, in brief terms, can be explained as a market form in which no
consumer or producer can influence the market price. Perfect competition has a market
equilibrium which is Pareto efficient. The defining characteristics of a perfectly competitive
market can be given as follows:

1. Atomicity : An atomic market is the one in which there are a large number of small
producers and consumers They are so small that individual actions have no significant impact
on others. Firms are price takers.
2. Complete information : All consumers and sellers know the prices set by all firms.
3. Homogeneity : All firms sell an identical product.
4. Free entry : No firm has barrier for entry into or exit out of market.
5. Uniform price: Each firm charges the same price in the market.

In addition to this, there are obvious behavioural assumptions such that the consumers try to
maximize utility while suppliers try to maximize profit.

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Expected benefits of competition
Introduce Generators become
competition more efficient

Production cost
Economy benefits
decreases

Price to consumers
Competitive market
decreases

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Fig. 1
The firm's supply decision under perfect competition

In a perfectly competitive market, there are many suppliers and consumers.

The selling or purchasing behaviour adopted by one market player will not

influence the market price ideally, the market price is at its marginal cost of

production.

Refer Fig. 1. on the previous slide.

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Imperfect Competition -
a. Monopoly - There is one only supplier. The market price is controlled by the supplier and sometimes
with limitations from other organization such as governments. The market price generally does not reflect
the production cost.

b. Oligopoly - There are few suppliers the selling behaviour adopted by one supplier has great influence
on the market price. The market price may not necessarily reflect the production cost. There exists market
power.
i. Cournot model - In the standard static Cournot game, the firms make their quantity
decisions at the same time, and each firm behaves independently to maximize its own profit. Cournot is
quantity based model and compete on sales volumes while Bertrand model competes on price.
ii. Bertrand model - As per Bertrand, if the price is used as the strategic variable amongst
rivalry firms, one firm get an incentive to cut other’s price in order the highest market share.

Emergent electricity market structure is more akin to oligopoly than perfect market competition. This is
due to special features of the electricity supply industry such as, a limited number of producers, large
investment size (barrier to entry), transmission constraints which isolate consumers from effective reach
of many generators, and transmission losses which discourage consumers from purchasing power from
distant suppliers.

c. Electricity markets under imperfect competition - If the electricity market is not perfectly competitive, a
power supplier may increase benefits by bidding a price higher than its marginal production costs. This
behaviour is called strategic bidding. This strategy imposes the risk of producing no profit at all if the bid
price is too high. It places the chance of the supplier’s bid being selected in jeopardy.

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Market Power –

It may be defined as owning the ability by a seller, or a group of sellers, to

drive price over a competitive level, control the total output or exclude
competitors from a relevant market for a significant period of time.
a. Sources of market power – Monopoly on pricing or availability of electricity

b. Effect of market power – Transfer of wealth from buyers to sellers or a

misallocation of resources.
Identifying market power -
i. Herfindahl-Hirschman Index (HHI) :

For example, for three suppliers with shares of 20, 30, and 50 percent the HHI would equal
3800 = (400+ 900+ 2500).

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ii. Entropy coefficient –

iii. Lerner index (LI)–

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Market Power Mitigation –
Market power has been a problematic issue for fair and transparent trades in various electricity
markets. Problems of existing market power mitigation methods are complicated judgment
criteria, excessive supervision probability, impersonal cost data accounting, and the requirements
on perfect information circumstances. A spot market power mitigation clearing mechanism
(MPMCM) manages to limit potential market power execution while avoiding overregulation and
maintaining a real market supply-demand situation.
I. Effects of contract for differences - In electricity markets, a contract for differences (CFD) is a
bilateral agreement in which one party gets a fixed price for electric energy (the strike price) plus
an adjustment to cover the difference between the strike price and the spot price. This adjustment
may be a positive or negative number.
CFDs are different than FTRs in two ways. First, a CFD is usually defined at a specific location, not
between a pair of locations. Thus, CFDs are a tool principally for hedging temporal price risk - the
variation in the LMP over time at a specific location. Second, CFDs are not traded through Regional
Transmission Operator (RTO) markets. They are bilateral contracts between individual market
participants.

ii. Role of demand side bidding –

In some electricity markets such as California, New Zealand and Spain, demand side bidding is
permitted for large consumers to react to electricity pricing. In this case the maximization of social
welfare approach should be employed for bid clearing, and the minimum price approach employed
in those markets only with supply side bidding is no longer fair to the sellers. This is because in this
case both the sellers and buyers are bidders, and the buyers are no longer passive.
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 Financial Markets Associated With Electricity Markets -

With a well-functioning financial market for electricity, the optimum price path will
be approached more closely and the fair competition in electricity market can be
promoted. Furthermore, financial markets for electricity can provide the market
participants with risk-management tools and smooth the volatility of the spot
price. The study on the financial market for electricity is very important for
establishing effective electricity market framework and trading mechanism. Based
on the introduction of financial markets for electricity in different countries, the
electricity derivatives are classified. Four problems in financial markets for
electricity are discussed below.
a. Forwards – If enough sellers and buyers are interested in trading electricity in
advance of delivery, a forward market for energy will develop. This market is essentially
a decentralized market in which electricity is sold using forward bilateral contracts. The
delivery time can range from days to years in the future.

b. Futures – It is an agreement between two parties to buy or sell energy at a certain

time in the future for a specific price. Both futures and forward contracts are firm
contracts.
Futures differ from forwards, however, in their standardization, exchange trading, margin
Requirements, and daily settling.

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Spot, forward and future contracts: unconditional delivery

c. Options – non-firm contracts; conditional delivery

Options: Options are contracts enabling their holders to buy or sell
energy at a specified price.
There are two types of options.
i) Call Option: right to buy at a certain price at a certain time
ii) Put Option: right to sell at a certain price at a certain time

d. Swaps – Contracts for difference (CFD). Swaps are used to lock in a

fixed energy price for a predetermined – though not necessarily
constant – energy quantity.

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Introduction To Optimal Bidding By A Generator Company -

a. Bidding in real markets

In restructured electricity markets, generators and other market

participants submit bids to the system operator, who dispatches
power while satisfying the system constraints. Dispatch establishes
the market clearing price for electricity at each node of the
network. The participants must develop bidding strategies that
maximize their joint profits from electricity and other related
markets.
The Real Time (RT) market is always run by a system operator.

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Optimal Bidding Methods.

The maximization of profit for power companies is highly associated with the bidding strategies. In
order to maximize the profit, participants need suitable bidding models. In an open access electricity
market, the bidding problem is a complicated task because of producer’s uncertain behaviours and
demand fluctuation. Therefore, developing bidding strategy is extremely important for electricity
market participants to achieve the maximum profit.

Methods :
a. Game theory - Generators with significant market share may attempt to increase profits by
shifting their bid curves to the left, thus driving up the market clearing price.
b. Markov decision process - The decision-making problem is formulated as a Markov decision
process-a discrete stochastic optimization method. All other suppliers are modelled by their
bidding parameters with corresponding probabilities.
c. Genetic algorithm - Artificial Intelligence Technique based on Darwin’s theory – survival of the
fittest.
d. Equilibrium analysis - Equilibrium models represent the market behaviour taking into
consideration competition between all participants.
e. Conjectural variation (CV) - CV based bidding strategy (CVBS) method can help generation firms
to improve their strategic bidding and maximize their profits in real electricity spot markets
with imperfect information
f. Bayesian analysis - Bayesian inference approach is used to reveal the aggregate supply curve in
a day-ahead electricity market. The algorithm relies on Markov Chain Monte Carlo and
sequential Monte Carlo methods. 13