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Does vertical integration have an effect on load factor?
– A test on coal-fired plants in England and Wales
N° 2006-03
February 2006
José A. LÓ EZ
Électricité de France
Evens SALIES
OFCE
Does vertical integration have an effect on load factor?
– A test on coal-fired plants in England and Wales *
José A. LÓEZ**
Électricité de France
Evens SALIES***
OFCE
Abstract
Today in the British electricity industry, most electricity suppliers hedge a large proportion of their residential customer base requirements by owning their own plant. The non-storability of electricity and the corresponding need for an instantaneous matching of generation and consumption creates a business need for integration. From a sample of half-hour data on load factor for coal-fired power plants in England and Wales, this paper tests the hypothesis that vertical integration with retail businesses affects the extent to which producers utilize their capacity. We also pay attention to this potential effect during periods of peak demand.
Keywords: panel data, vertical integration, electricity supply.
JEL Classification:C51, L22, Q41.
* Acknowledgements: we thank Guillaume Chevillon, Lionel Nesta and Vincent Touzé for their comments and suggestions. The authors are solely responsible for the opinion defended in this paper and errors.
** jose-antonio.lopez@edf.fr;
*** evens.salies@ofce.sciences-po, corresponding author.
Table of contents
1 Introduction.......................................................................................................p. 1
2 Vertical integration as a natural structure in an industry subject to particularities.....................................................................................................p. 4
2.1 Fragmentation of UK coal-fired electricity generation capacity....................p. 4
2.2 Drivers behind vertical integration.................................................................p. 4
2.2.1 Hedging customers.............................................................................p. 5
2.2.2 Ensuring plant dispatch during peak demand periods........................p. 6
3 Does vertical integration have an effect on load factor?................................p. 6
3.1 Technical definition of load factor.................................................................p. 6
3.2 Distribution of load factor..............................................................................p. 7
3.3 Conditional model for load factor.................................................................p. 8
4 Results.................................................................................................................p. 9
5 Conclusion........................................................................................................p. 11
Bibliography.....................................................................................................p. 13
Appendices.......................................................................................................p. 14
Does vertical integration have an effect on load factor? – A test on coal-fired plants in England and Wales
1 Introduction
Today, most electricity retailers hedge their supply by owning their own plant. Thus most electricity retailers face a trade-off between the cost of dealing with market uncertainty and the cost of managing production units. The non-storability of electricity and the corresponding need for an instantaneous matching of generation and consumption creates a need for integration (Kahn, 2002: 46). A supplier that owns physical production capacity can bypass the volatile and often illiquid electricity exchanges in order to hedge its customer base. Unlike Industrial & Commercial customers, who often are offered contracts indexed to electricity exchange related prices, residential customers are charged (for the time being) with prices that do not reflect real-time conditions. 1
Electricity is a basic good thus nearly all electricity customers must be given some assurance against energy shortages and rationing. As mentioned in the previous paragraph electricity retailers supply electricity to domestic customers at prices that are not forcibly linked to real-time wholesale prices. Like for any non-storable good, retailers must respond to uncertain demand in the short term by sourcing from capacity that is inflexible in the short-term. 2 The fact that in the short-term to mid-term the electricity supply curve is inelastic can thus lead to significant wholesale price spikes. 3 Note that in general off-peak, prices yield insufficient income to pure generators, which implies that peak profit maximisation strategies may seek to balance off-peak losses (Fitoussi, 2003: 43)
The California experience has made it clear that market system design can have negative consequences for consumers and other stakeholders in the well functioning of
1 Furthermore there are logistical constraints on the number of times per year that a large supplier can adjust its prices, on top of regulated notice periods of notice (currently 28 days in the British electricity market).
2 Maintenance, repairs, equipment failures of power plants and primary input price fluctuation (coal in coal-fired plants, etc.) add to this uncertainty.
3 In fact some economists have asked themselves the question, why spikes are not observed more frequently and with more intensity, probably the result of some sort of self-restraint.
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José A. LÓEZ, Evens SALIES
the physical electricity system. Agents in the electricity sector are dependent on each other since failures in any part of the system can affect other firms’ costs in the short term 4 (Delmas and Tokat, 2003: 8). These constraints are compounded by the fact that in the short term residential demand is not contingent on prices, particularly because of the political and logistic difficulty of confronting them with the wide fluctuation in marginal supply costs on a real-time basis (see Kahn, 2000: 46).
The industry structure of the mid-merit coal-fired generation sector in the UK is the result of several mandatory and voluntary plant divestments and subsequent re-concentration. Before 1990 each regional supplier (ex-Regional Electricity Company) was vertically integrated with a distribution network, whilst National Power and Powergen owned most of the thermal generation assets (78%). 5 Plant divestments along with new entry took place, thus reducing both National Power and Powergen’s share of generation capacity and fragmenting the electricity generation industry.
Though some market power remains under the New Electricity Trading Arrangement (NETA) (Bower, 2002: 11-12), estimates suggest the “pivotal player strategy” is less often used in the wholesale energy market in England and Wales as a result of the increasing fragmentation of capacity ownership (Frontier Economics, 2003). 6 Plant divestment was accompanied with a rapid move to vertical integration (VI) of generation businesses with supply businesses (once initial regulatory barriers had been lifted). Today’s present market structure is marked by the dominance of the residential supply market by six large vertically integrated firms (albeit the degree of vertical integration varies amongst them, there is a tendency to converge upon a similar business model).
Vertically integrated retailers are less exposed to price volatility as they can internally adjust production (supply) to their load (demand) requirements (Delmas and Tokat, 2003: 9) at a lower cost than the one they might face in the wholesale markets. This
4 Notably the failure of ENRON and other energy traders subsequently increased the amounts of collateral requested by most electricity traders from remaining counter parties to cover credit-risk.
5 Whilst nuclear remained in the hands of British Energy and BNFL.
6 The exercise of market power as a result of capacity withholding by multi-plant producers seems to have been more extreme in California than elsewhere (Kahn, 2002: 47).
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Does vertical integration have an effect on load factor? – A test on coal-fired plants in England and Wales
efficiency may be passed on to customers. Among other authors Kahn (2002: 49) believes that continued ownership of generation by suppliers in California would have protected them but they accepted the obligation to freeze their retail rates and subsequently found themselves in great financial penuries as wholesale prices spiked persistently.
By monitoring the performance of their generators, integrated retailers can improve supply reliability and accordingly earn returns from alleviating moral hazard problems. It is thus expected that VI is related to the extent to which producers utilize their available capacity, especially in periods of peak demand. Whilst, at the same time VI may raise policy concerns as it increases market concentration and may reinforce the dominant position of an incumbent.
The main question raised in this project is whether VI plays a significant role in explaining the distribution of load factor (LF). LF can be defined as the ratio of the output produced by a plant in a certain period and the theoretical maximum that it could have produced. If LFs were higher for vertically integrated firms, more particularly, during peak times then we could conclude that VI has a role to play in limiting gaming in the wholesale electricity production market. Obviously LFs may be influenced by several other determinants such as seasonality, plant vintage, and plant scale. We essentially address these issues from a multivariate statistical approach applied to data on ten coal-fired power plants in England & Wales in a typical day.
The plan is as follows. In section 2 we suggest a few rationales underlying VI of generators with retail businesses. It is also suggested that the incentive to merge is higher for electricity retailers than for producers who still may have an incentive to “game” the market. Section 3 explores the distribution of LFs in more detail and sets up a multivariate model to test whether it is influenced by VI, particularly during peak times. We are also enable to measure the marginal effect on LFs of the size of plants, which indirectly gives precious information about the technology that relates supply to owned capacity. Section 4 presents the results. Section 5 concludes.
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José A. LÓEZ, Evens SALIES
2. Vertical integration as a natural structure in an industry subject to particularities
2.1 Fragmentation of coal-fired electricity generation capacity
The coal-fired generation duopoly of National Power and Powergen was able to exercise a considerable amount of market power in the Pool, especially after March 1993 when the vesting coal contracts expired. As privatisation began, reduction in industry concentration in the generation sector was effective in reducing market power thus lowering prices (Green, 2004; Bower, 2002). Specifically by the time the New Electricity Trading Arrangements (NETA) were implemented, the coal-fired generation sector had become fragmented amongst over eight firms. Overall capacity concentration fell by 3856 points over the period April 1990-March 2002 as measured by the HHI index (Bower, 2002: 30).
In July 1998 Powergen was allowed to vertically reintegrate its generation business with the supply business of East Midlands Electricity in return for further divestment. Similarly National Power bought the retail business of Midlands Electricity Board in June 1999. 7 In a subsequent voluntary round of divestment, Powergen divested plant to British Energy and London Electricity (today EDF Energy) before in turn being itself taken over by E.ON in July 2002. National Power reduced its coal-fired capacity too and was later taken over by RWE in May 2002. New entrants invested in combined cycle gas turbines (CCGT) plant that initially enjoyed a cost advantage due to coal vesting contracts and low wholesale gas prices.
2.2 Drivers behind vertical integration
Retailers face uncertainty about the cost of sourcing the electricity they are to supply to their customer base. This economic uncertainty is a source of market transaction costs (Spulber, 1999: 236-). Following the transaction costs literature, VI may be
7 Powergen sold Fiddlers Ferry (1960 MW) and Ferrybridge (1956MW) to Edision Mission energy whilst National Power sold Drax (3870MW) to AES.
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Does vertical integration have an effect on load factor? – A test on coal-fired plants in England and Wales
economically founded as it is sometimes cost effective to internalize some transactions, organising and coordinating them within a hierarchical firm (Grossman, 2003: 23). According to Bower (2002), the NETA gave large consumers and suppliers an incentive to undertake active load and price risk management. Consequently they can alleviate the costs of dealing with market uncertainty (the amounts of electricity they purchase) (Spulber, 1999: 270) through VI and control over generation, which may increase reliability of input supplies. 8
2.2.1 Hedging customers
Residential end-customers do not contract directly with generators. The social cost of a decentralised matching market would be certainly higher than transacting with electricity retailers. Basically these latter act as market makers (they interface end-customers and producers who ship electricity via the grid and distribution networks). It is worth noting that long term contracts may decrease the transaction cost gains from VI. Although long term contracts have the virtue they can reduce wholesale electricity prices (Green, 2003), vertically integrated retailers can handle information asymmetries more effectively in the short term. Also long-term contracts present risks for the retailer (counter party credit risk, lack of flexibility, amongst others).
In the E&W market coal plant sometimes runs during periods of high demand. During peak demand, opportunistic gaming behaviour can be more profitable for independent generators and the importance of appropriately hedging domestic customers becomes even bigger. VI may alleviate opportunistic behaviour (plant capacity withdrawal) by otherwise pivotal generators and thus increase LF. The most obvious reason is that being a retailer may give producers, particularly pivotal generators, an incentive to increase supply as they have contractual obligations vis-à-vis their customers at a fixed price. These generators could otherwise have benefited from withholding capacity (López, 2002; Bower, 2002). Finally since generators learn about the amount of their resource stock one period before the market clears, retailers may seek to acquire more
8 Kahn (2002: 46) emphasizes the high degree of interdependence between investments and operation at the transmission and generation levels presumably taken into account internally by the several vertically integrated franchised monopolists that used to dominate the US electric industry. VI provides incentives for undertaking investments at one horizontal level necessary for the success of operations at another. 5
José A. LÓEZ, Evens SALIES
than one generation units, thereby eliminating uncertainty about the total amount of available supply. 9
2.2.2 Ensuring plant dispatch during peak demand periods
In general power plants find it profitable to produce electricity during peak time when whole sale prices are higher than average. By calling their peaking plant, there is certainly a trade off between withholding capacity until price reaches a certain level and producing hence making money now (Green, 2004). Today capacity withholding is however less often observed as stated in section 2.1. VI may thus allow generators to dispatch their peak-load plants with lower coordination costs. This assertion will be tested econometrically.
The existence of a link between LF and VI would thus be informative about the extent to which producers may be attempting to “game” the market (by withholding load at peak demand periods for example). A positive relationship between VI and LF would suggest that vertically integrated producers seek rents in a less opportunistic way than independent producers.
3 Does vertical integration have an effect on load factor?
3.1 Technical definition of load factor
Traditionally LF is a measure linked to a theoretical maximum output capacity measure and it can be defined as the ratio of the output produced by a plant in a certain period and the theoretical maximum that it could have produced. Thus a yearly LF would equal the total output of a plant in a year divided by the maximum possible output of that plant also in a year. LFs can be measured in hours, days, weeks, or whatever other time period one deems appropriate.
9 Demand seasonality gives an incentive to acquire generation plants of different capacity to operate near full capacity for a greater amount of time thus reducing average costs. It is worth noting that a retailer holding all installed capacity in the sector would still face uncertain demand.
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Does vertical integration have an effect on load factor? – A test on coal-fired plants in England and Wales
It is different from the availability factor (AF) that is the ratio of gross electric output over a given period of time to the amount of electricity that could be produced if the plant were operating at capacity for the entire time, excluding scheduled downtime periods. 10 AF gives higher values than LF when used to assess the performance of any particular plant (Virdis and Rieber, 1991). LF is a key indicator as it is the relevant concept for
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