Regulating Competition in Wholesale Electricity Supply

The experience of the past twenty 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. 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. The major theme of this chapter is that electricity industry restructuring 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 all stages of the production process. A fundamental goal of that process is to limit the ability of suppliers to exercise unilateral market power in wholesale generation markets, either explicitly through market price-setting mechanisms or implicitly through the regulatory price-setting process. Some ways the regulator can limit the ability of suppliers to exercise unilateral market power are to (1) alter the market structure, (2) change market rules, (3) impose penalties and sanctions on market participants for their behavior, and (4) 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 designing a wholesale electricity generation market that provides consumers with greater benefits relative to those under the former vertically integrated regulated monopoly regime.