Generators inflate prices through market power

The Energy Users Association of Australia, concerned about the level of generator competition in the NEM, commissioned Carbon Market Economics to undertake an analysis of the wholesale electricity market in South Australia over the period from 2008 to 2011.

Over this period, higher average spot prices in South Australia, compared to other parts of the NEM, are attributable to a few half-hourly settlement periods typically in the last few weeks of January or first two weeks in February during which prices reached extremely high levels.

The analysis in this paper suggests that spot market prices in these periods reflect the exercise of market power rather than scarce supply. The South Australian electricity system appears to have ample capacity even at the times of peak demand.

Evidence of the exercise of market power in South Australia

The level of “spare” capacity in a market at the times of extremely high prices can be used to draw conclusions on whether those high prices reflect the exercise of market power, or whether they reflect the reasonable outcome in a market where there is scarcity of supply.

If the market is competitive, generators would seek to maximise production when prices are higher than their production costs. If the evidence is that they consistently have spare capacity when prices are extremely high, then this can be taken as evidence that they have withheld capacity from the market (or, equivalently, only made it available to the market at much higher prices).

The analysis of the very high priced settlement periods in South Australia suggest that there has not been a scarcity of supply at these times. When extreme prices occurred, typically (but not always) at times of very high demand, there were still substantial amounts of generating capacity that could have been made available to the market, but was not.

For example, in 2008 for the half hourly settlement periods when the South Australian spot prices were at the Market Price Cap of $10,000 per MWh, there was on average 667 MW of generating capacity at the Torrens Island Power Station that was not producing electricity. Similar outcomes occurred in 2009 and 2010.

In 2011 however the situation changed. This time the Torrens Island Power Station generating units were producing at or near their full capacity, while the brown coal generators (Playford and Northern) had substantial amounts of capacity unavailable (on average 423 MW) when the market price was at or near the Market Price Cap.

For 2012 to-date, the highest price in half-hourly settlement periods in the spot market has been just $147/MWh – a fraction of the peak price in the previous 5 years –suggesting generators have not exercised market power in 2012.

Impact of the exercise of market power on consumers

The effect of extreme high spot prices in South Australia, on average annual spot prices in South Australia, has been particularly significant. In some years, the extreme prices that occurred for less than 0.4% of the year, more than doubled the average annual spot price from what it otherwise would have been.

The extreme spot prices in South Australia have also resulted in a significant divergence between average prices in South Australia and those in other NEM regions. Specifically, while spot prices in South Australia have typically been comparable to the spot prices in the other regions of the NEM for 99.6% of the half-hourly settlement periods in a year, the extreme prices in South Australia in a few settlement periods have raised the average annual spot prices (in South Australia) by more than 50% when compared to the rest of the NEM, for the period from 2007 to 2011.

The extent to which spot price outcomes have affected electricity consumers depends to a large extent on outcomes in contract markets (for non-household consumers) and prices for residential consumers on standing contracts with AGL (as determined by the Electricity Supply Commission of South Australia).

The data suggests that contract market outcomes have tended to follow spot market outcomes, so that outcomes in spot markets have been passed through to end users in due course.

Impact on non-residential electricity consumers

With regard to contract market outcomes, other than in the first quarter of each year, the quarterly Base futures contract prices in South Australia have been predictable and comparable to prices in other regions of the NEM over the period from 2007 to 2011. The price of this contract has seemed to roughly match the outcomes in the spot market over the same time periods.

However, quarterly Base futures prices in the first quarter of each year have been substantially higher in South Australia than in other regions of the NEM in the period from 2008 to 2010. This reflects the significantly higher average spot prices in South Australia in the first quarter of each year compared to the rest of the NEM.

The outcomes in 2008, suggest that the contract market failed to fully recognise the impact of the exercise of market power in that year, on average spot prices. Since then, and up to 2012, however, the quarterly Base futures prices have matched average spot prices reasonably accurately. In 2012, the quarterly Base futures price for the first quarter have been substantially higher than the spot price reflecting the inability of the contract market to anticipate the absence of market power in the spot market in the first quarter of 2012. Broadly, however, the conclusion on contract market outcomes is that for several years, the futures contract market has reasonably accurately anticipated spot market outcomes

Impact on residential electricity consumers

With regard to residential electricity consumers, the picture is fairly clear: the Essential Services Commission of South Australia calculates the prices that AGL is able to charge small consumers on standing contracts in South Australia. Retailers compete, possibly offering discounts to these tariffs, in order to attract customers. The AEMC's report on retail electricity prices shows that in the calculation of residential electricity prices in South Australia (based on AGL's standing contract), wholesale electricity prices are higher (typically about 20%-30%) in South Australia than in other NEM regions.

Impact of the exercise of market power on generators

The extreme prices in a few settlement periods has made the least difference to wind farms, causing their spot market revenues to rise by around 25% from what they otherwise would have been. For brown coal generators, Combined Cycle Gas Generators (CCGT) and Torrens Island Power Station B (“Torrens B”), the high priced settlement periods roughly doubled the average annual spot market revenues. For the Open Cycle Gas Turbines (OCGT), and Distillate plant, the high priced events accounted for almost all their spot market income.

For those generators that were actually exposed to spot prices (i.e. had not entered into financial contracts to hedge spot prices) the high prices will have significantly improved their profitability. For example, for Torrens B the high priced events delivered revenues of $332m over the four years. Per MW of capacity, this translates into about $0.7m per MW of capacity.

The high priced events from 2008 to 2011 delivered $374m of spot market revenue for the 729 MW of OCGT plant in South Australia. Assuming, hypothetically, that this plant was unhedged (i.e. fully exposed to spot prices), this translates into revenue of $0.5m per MW, a little bit less than the OCGT plant would have cost to build. To put this another way, less than two years of these extreme spot prices would have allowed the owners of this OCGT plant to recoup most of their capital outlay. This is for generating plant that has an expected operating life of many decades.

Most of the South Australian generating capacity will have been hedged against the spot price either by entering into contracts, or by virtue of vertical integration with retailers.

In practice therefore only some of the generation capacity (possibly most of the output from the Torrens Island Power Station) would have received the full benefit of the extreme spot prices in the period to the end of 2010.

However, as discussed, higher spot prices have flowed into higher contract prices (and regulated tariffs), and in this way generators (and retailers) have, over time, benefitted from the higher spot prices that occurred in the period from 2008 to 2011.

This is an edited extract from the report: ‘Electricity market power in South Australia', for a full copy of the report and to read the recommendations flowing from this analysis click here.