Vertical Integration and Market Power in Electricity Markets

Abstract

Vertical separation of generation from electricity retailing has often been required as a condition of electricity market liberalisation. A well-developed and liquid contracts market is similarly suggested as necessary to manage the resulting wholesale market risks, which risks are further exacerbated by competition. Such contracts markets are rare, however, and increasingly evidence is emerging that vertical integration is associated not just with improved wholesale market risk management, but also reduced wholesale market power. This paper develops a theoretical model showing that non-vertically integrated generators will over-report their inverse supply curves, with the incentive to over-report increasing with the firm’s share of generating capacity. Conversely, in a vertically integrated industry, no over-reporting occurs when integrated firms have balanced shares in wholesale and retail markets. In general, firms whose share of generating capacity is higher (lower) than their retail market share will over-report (under-report) their inverse supply functions. Integration is found to affect retail electricity prices only via its effect on retail marginal costs. We find that retail prices are higher with vertical separation than with either balanced integration, or full integration without a wholesale market. These results suggest a re-evaluation of the importance of generator wholesale market power in vertically integrated electricity industries, and of measures to improve retail market competitiveness under either vertical integration or separation.