Lecture 7: Regulation

Question 1

How is the profit maximizing in the competitive market and monoply?

Answer 1

Competitive output choice
Price = marginal cost,
so where the marginal cost curve (demand curve) meets the Demand curve, we have the competitive market equibilirum. At this point we have surpluses, one there is producer surplus and other there is consumer surplus

Monopoly output choice
Marginal revenue = marginal cost
this gives us the quantity, the price corrospending to that quantity is to be found in the respecting Demand Curve

Question 2

High fixed costs competition can not be sustained due to the resulting …… Why?

Answer 2

Fixed Costs and constant marginal costs imply that avarege costs are falling in output (je höher die Output, desto geringer avarage cost). In that kind of cost structure a single producer is strictly more efficient than multiple producers.

Question 3

the avarage cost might not be falling in the whole output range but only in releavnt demand range. *
(However, this decrease in average cost doesn’t continue indefinitely. There comes a point where making even more lemonade doesn’t reduce your average cost anymore. This is because you might have limited space or equipment, or it becomes difficult to manage everything efficiently. This is the relevant demand region we mentioned earlier.
So, the minimum efficient scale is the output level (the amount of lemonade you make) that minimizes your average cost. It’s the point where you’re producing the right amount of lemonade to keep your costs as low as possible while meeting the demand from your customers. It’s like finding the perfect balance between making enough lemonade to make a profit and not making too much that it becomes inefficient and costly.)
*

If the MES is comparable to demand at minimum Avarage Cost Market cannot support two profitable competitors -Monoply

if the MES is much smaller than the demand at minimum Av. Cost market is able to have mire competitors

Question 4

Definition of Natural Monopoly

Answer 4

A natural Monopoly is a monopoly created
and sustained by economies of scale over the
relevant range of output for the industry

Question 5

How to deal with natural monopolies? Four generic policy options

Answer 5

A) Socialization
* Regulation that sets p = MC: welfareoptimal
* Losses are covered by subsidy

B) Average cost pricing (“Second-best”)
* Operate at p = AC: higher than welfareoptimal
price
* Firm breaks even, no subsidy required
* Firm benefits from short-term cost savings

C) Licensing
* Operate at p = MR: higher than AC
* Society profits from monopoly rent in the
form of license payments
* Incentives for operational efficiency are
preserved

D) “Let it be”
* Operate at p = MR
* Incentives for both entrepreneurial activity
and operational efficiency are preserved
Inefficient price and output choice can create
substantial welfare loss; society does not
profit from

Question 6

What is the typical choice of the public service industries? How about dynamic industries, such as software.

A) Socialization
* Regulation that sets p = MC: welfareoptimal
* Losses are covered by subsidy

B) Average cost pricing (“Second-best”)
* Operate at p = AC: higher than welfareoptimal
price
* Firm breaks even, no subsidy required
* Firm benefits from short-term cost savings

C) Licensing
* Operate at p = MR: higher than AC
* Society profits from monopoly rent in the
form of license payments
* Incentives for operational efficiency are
preserved

D) “Let it be”
* Operate at p = MR
* Incentives for both entrepreneurial activity
and operational efficiency are preserved
Inefficient price and output choice can create
substantial welfare loss; society does not
profit from

Answer 6

Case B- Avarage cost pricing,
Case D- Let it be

Question 7

Grid operation is considered a natural monopoly, generation and
distribution are not, why?

Answer 7

Because the “Natural” market structure is governed by cost structure and in the grid operation side there are lot of investment costs involved with very low marginal costs, where as in the generation side there is multiple MES, which means diffrent componies with diffrent cost structures can meet the demand

Question 8

What are the key determinants of the competitiveness of a power market?

Answer 8

1) Demand elasticity
* Low electricity demand elasticity
Ø Increase operating reserve à increase of operator´s demand elasticity
Ø Introduction of real-time prices à Increase demand elasticity
2) Supplier concentration
* Low supplier concentration in the power market
Ø Reduce market power by reducing supplier concentration
3) Extent of long-term contracting
* Market power cannot be exercised in derivatives (forwards and future) and dayahead
markets
* Market power can be exercised in real-time markets
Ø Increase extent of long-term contracting
4) Extent of supply curve bidding
* Set price above marginal cost but below the price cap of a specific quantity
* Supply bids are used to exercise market power when demand is uncertain
* Supply bids are more profitable if only one supplier applies it
* If all suppliers apply supply bids, all of their profits are reduced
* Supply-bidding increases competition

Question 9

Which two options of smart grid running did we learned?

Who should own the smart grid? Do we need new regulation?

Answer 9

Depending on the regulation, the smart grid may look very different.Two extreme organization forms can be envisioned. Distributors (whole sale market) run ICT or Grid operators run ICT.

Question 10

explain the smart grid which is run by the distribution companies?

Answer 10

A smart grid run by distribution companies will focus on smart meter marketing:

§ Establishing and marketing smart metering in the retail business may be the main development driver
§ Competition around attractive and innovative retail power products (services, tariffs)
§ Due to unbundling regulation it is unclear how grid operator could benefit from smart grid monitoring capabilities
§ Distributors may seek heterogeneity of smart metering
landscapes to facilitate retail customer lock-in – multiple
smart grids per distribution grid
§ Competitive smart grid operation may limit access for
smaller players – large integrated firms in advantageous
position

Question 11

Defining Market Power

Answer 11

• Economic definition
• “The ability to alter profitably prices away from competitive levels.”
  (Mas-Colell et al. 1995; emphasis R.M.)
• Regulatory definition
• “Market power to a seller is the ability profitably to maintain prices above
  competitive levels for a significant time.” (DOJ, 1997)
• Three-step process:
  1) An exercise of power
  2) An effect on price and quantity
  3) An impact on market participants
• Strategy of withholding
• “Producing less than would be profitable, assuming all output could be sold at
  the market price. Not acting as a price-taker. This strategy may be executed
  “financially” by bidding high or “physically” by curtailing output.”

Question 12

The grid can be conceptualized into three “layers”, which are they?

Answer 12

Markets & business models
(EEX, OTC, balancing
power markets)

ICT layer (grid control and
monitoring systems)

§ Physical layer (cable,
transformers, switches)

Question 13

Intelligent grids are already in place in the high and medium voltage grids:

Answer 13

High- and medium voltage grids are generally
equipped with network control technology

Markets for electricity and balancing power provide
incentives for investments in appropriate technologies

Question 14

Intelligent grids not yet in place in the low voltage grid hierarchy

Answer 14

So far only punctual field test experiences with “intelligent” low voltage grids

Business models:
Nothing except run-of-themill
retail electricity contracts

Question 15

• Three participating parties interact with, and mutually influence, each other in the grid regulation process:…….., …………, ………..

Betwenn them there is ….., the lack of property rights and information …..

Arising conflicts likely between the goals of the ….. (as the principal) and the ….. (as the agents)

The regulator’s target is to raise/maximize ….. (by reducing total energy system costs etc.), the DSOs aim at ……

the …. aims at inciting the DSOs to act in a more efficient and welfareoriented way – by linking their profits to societal goals

Answer 15

• (1) Legislator
• (2) Regulatory authority
• (3) Regulated DSOs

-Principal Agent Problems
-Assymetries

• regulatory authority
• DSOs
  \
• social welfare
• Profit Maximazation
  
  incentive regulation
  \

Question 16

Agrell2013

In which 4 ways DSO / DER regulation can be effected?

Answer 16

1. Integrated regulation:
2. Decentralized regulation:
3. Centralized independent regulation
4. Centralized conditional regulation

Question 17

What is Integrated regulation

Answer 17

An integrated DSO/DER entity considers the total cost of undertaking smart grid investments; the regulator, who does not know the costs but only forms expectations, makes a take-it-or-leave-it offer to the integrated entity.

Question 18

What is Decentralized regulation?

Answer 18

• Regulator makes an offer to the DSO, and the latter decides what to offer to
  the DER investor.
• If the DSO investment costs exceeds the budget alone no investment can take
  place.
• The regulator’s desire to limit the DSO-DER information rents will generally
  lead to underinvestment.
• The DER investor is rationed more harshly than the DSO, because the DSO
  must pass on information rents to the DER investor.

Question 19

What is Centralized independent regulation

Answer 19

• The regulator signs separate and independent contracts with the DSO and DER, and rations to lower information rents.
• Implies a unilateral commitment by the regulator to finance the investment irrespective of the coordination in the supply chain.

Question 20

What is Centralized conditional regulation

Answer 20

• First, the regulator offers an investment possibility to the DER investor
• If the latter accepts and undertakes the investment, the regulator also offers the
  investment to the DSO
• Obvious advantage: avoids situations where the DSO invests but the DER
  investor does not
• Outcome may often be that the regulator should refrain from any investment
  to begin with (i.e. like in the variant with individual regulation).
• Assumption that the regulator can make a conditional regulation in the sense
  that a separate contract is offered to the DSO and the DER investor first
• An accepted contract by one party becomes only valid if the other party
  accepts the contract it was offered, too (thus avoiding the losses inherent in the
  unconditional centralized variant that arise when only one party accepts)

Question 21

Explain the EEG act and the Feed-in tariff system and what the problem was?

Answer 21

The problem was that due to the overachievment of the capacity golas the EEG Levy got up to 30cent per kWh, which then increase the cost of the customer. and with the higher prices PV systems are increasingly used to cover own consumption instead of feeding the entire generated electricity into the grid

Question 22

UE07

Q1) Explain the concept of market power. When does a frim exercises market power?

What is the central Idea?

Answer 22

A firm exercises market power when it reduces its output or raises the minimum price at which it is willing to sell output (its offer price) in order to change the market price
* Firm risks to sell less, but raises price
* Profitable because the gain in profit by selling all the output (after the market price is increased), is greater than the loss it faces by selling fewer units (if that occurs)

Central idea behind market power is In a market where all output is sold at (or nearly at) the same price, a firm that can influence price in the market will do so in order to raise the price for all the production it sells

Question 23

UE07

Who is a price taker firm?

Answer 23

A firm that is unable to exercise market power
The firm takes the price it faces for its output as given
It sells all of its output at the market price, which is set by the interaction of demand and all supply in the market
The price taking firm is willing to sell at the market price any output that it can produce at a marginal cost less than the market price

Question 24

UE07

There is no economic argument for the necessity of market power to ensure the viability of the industry. What is the main arguement for necessity of market power:

Answer 24

In absence of market power marginal cost pricing will leave nothing to cover fixed costs and firms will not be profitable enough to survive

Reason in a competitive market with no barriers to entry: In the long run equilibrium, all generators are able to cover their fixed costs and no other generator could enter and cover its fixed costs at the current market prices

Process of entry and exit:
New generation enters market if the net revenue earned (after covering variable operating
costs) is more than enough to cover the fixed costs for some type of generation
* Generation exits the market if the net revenue is less than enough to cover the fixed costs
for some type of generation
supply curve in the industry shifts to the left and the equilibrium market prices rise
all remaining firms earn higher prices and greater contributions to fixed costs

Question 25

UE07

Q3) Electricity markets are, all else equal, more vulnerable to the exercise of market power than are other energy markets. Why?
What are the factors which influence the profitability of the exercising market power?

Reasons for the non existence of market power in the electricity market

Answer 25

Price elasticity of demand
Price elasticity of supply
Market share (not necessarily)

Homogenous products
Selling them over a large geographical area (if transmission capacity between
different markets is sufficient)

Question 26

UE07

Discuss the Price elasticity of demand

Answer 26

High price elasticity (high sensitivity to price changes)
Already small price raises foster a demand reduction
Exercising market power is less profitable
Low price elasticity
Large price increase necessary to reduce demand
Exercising market power is more profitable

Question 27

UE07

Discuss the Price elasticity of the supply

Answer 27

High price elasticity
Increasing the price or reducing the output would bring additional supply by other suppliers
Exercising market power is less profitable

Low price elasticity
Other suppliers would only increase supply if the price increase is high
Exercising market power is more profitable

Question 28

UE07

Discuss the Market Shares effect on Market power

Answer 28

Low market share
Demand and price would not have to adjust very much to absorb the loss of part of the
firm’s production

Other companies probably could expand their output by the small amount necessary to replace the firm’s reduced production without driving up their own costs appreciably
–Low ability to exercise market power
–High ability to exercise market power if demand elasticity is extremely low, demand is
very high and supply elasticity is very low

Large market share
Demand cannot adjust to output reduction, since the amount is too high
Other companies cannot replace the output
High ability to exercise market power

Question 29

UE07

Could the smart grid paradigm improve the robustness of electricity market? Why?

Answer 29

Characteristics of the smart grid paradigm and effects on robustness:

Decentralized production– smaller market share possible

Demand flexibility – higher sensitivity of demand to price changes

Supply flexibility – often lower fixed costs and higher sensitivity of other producers to price changes

Better data and demand management due to ICT – more price and demand information for the consumer

Question 30

UE07

Referring to the notes in the lecture slides, please answer the following questions:

What are the characteristics of a natural monopoly?

Answer 30

Characteristics of a natural monopoly:

*“A natural monopoly is a monopoly created and sustained by economies of scale over the relevant range of output for the industry”

If industry profits are strictly positive with one firm operating and strictly negative with two firms the industry is a natural monopoly

Arises when producing the goods involves large fixed costs and relatively small variable costs

—>It is most efficient to concentrate production in a single firm

Question 31

Q2) Which of the following would you categorize as a natural monopoly, and why: power generation, power distribution, and grid operation?

Answer 31

The Minimum Efficient Scale (MES) is the smallest amount of production a company can achieve while still taking full advantage of economies of scale with regards to supplies and costs. In classical economics, the MES is defined as the lowest production point at which long run a verage t otal c osts (LRATC) are minimized
*
The MES is equal to the output level which minimizes the average cost
*
The MES is comparable to demand, thus the market does not support more than one profitable competitor

PG
High fixed costs for conventional power plants, but still there is no limit to just one profitable company
Lower fixed costs for renewables
Few entry barriers
MES is much smaller than the demand at minimum average cost
Competitive market

Power distributionDistribution activity boils down to marketing, which has few entry barriers
Competitive market

Grid operation
High fixed costs, low marginal costs of serving the customer
Only one grid can capture the economies of scale in a given region
MES is close to demand
Natural monopoly

Question 32

UE07

Q3) The smart grid can be conceptualized into three layers: the physical layer, the ICT layer, and the
market and business model layer. How should the ICT layer be operated? In a Comp. Market, distributors run ICT

Answer 32

+ Main development driver
+ Competition around attractive and innovative
retail power products (services and tariffs)

-Distributors may seek heterogeneity of smart
metering landscapes to facilitate retail customer
lock in multiple smart grids per distribution
grid
-Competitive smart grid operation may limit
access for smaller players large integrated
firms in advantageous position

Question 33

UE07

Q3) The smart grid can be conceptualized into three layers: the physical layer, the ICT layer, and the
market and business model layer. How should the ICT layer be operated? In a Natural Monopoly Market, ^Grid Operators run ICT

Answer 33

+ Main focus is on improving distribution grid
operations
+ Standardization

-Hard for regulators to determine an efficient ratio
between investments in ICT vs. physical
technology
-Regional differences may be ignored by requiring
a minimum smart grid everywhere

-Regulated access to a common platform may, or
may not, act as a catalyst for developing new
business models and services

Might impede innovation