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Regulating Competition in Wholesale Electricity Supply
Working Paper

Published By

Stanford University, Department of Economics

November 12, 2007

Abstract

The experience of the past ten years suggests that the potential benefits from electricity industry restructuring are small relative to those that can be achieved from introducing competition into other network industries such as telecommunications and airlines. In addition, the probability of a costly market failure in the electricity supply industry, often due to the exercise of unilateral market power, appears to be significantly higher than in other network industries.

A major theme of this chapter is that electricity industry re-structuring is an evolving process that requires market designers to choose between an imperfectly competitive market and an imperfect regulatory process to provide incentives for least-cost supply at various of stages of the production process. The fundamental goal of the market design process in the wholesale market regime is to limit the ability of suppliers to exercise unilateral market power either explicitly through market price-setting mechanisms or implicitly through the regulatory price-setting process.

There are a number ways the regulator can limit the ability of suppliers to exercise unilateral market power-namely, (1) alter the market structure, (2) change market rules, (3) impose penalties and sanctions on market participants for their behavior, and (4) even explicitly set the prices that market participants receive for their production. This chapter provides a theoretical framework for understanding how to make these choices in order to design a wholesale market that benefits consumers relative to the former vertically-integrated utility regime. The paper uses this framework to understand the causes of the disappointing experience with wholesale electricity restructuring in the US. This discussion points to a number of ways to increase the likelihood that restructuring in the US will ultimately benefit consumers.

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