Rowan Walshaw, Kieron Meagher

Vertical Integration and Capacity Competition in Electricity Markets

Introduction

Vertical integration and capacity competition in electricity markets. Analyze vertical integration's impact on electricity market price competition and strategic capacity withholding. Discover how it fosters competitive pricing and eliminates capacity manipulation.

Abstract

This paper characterises the impact of vertical integration on price equilibria and incentives to strategically withhold capacity in a wholesale electricity auction. A two-stage game is analysed where vertically integrated firms first declare the quantity of electricity available and then compete in a uniform price auction. Consistent with empirical literature on electricity markets, the model finds that firms’ incentives are determined by their net demand position in the market. Results indicate that for the majority of parameter values, a vertically integrated structure yields a greater occurrence of competitive pricing in the wholesale market. Contrary to recent analysis of non-integration, vertical integration eliminates incentives for strategic capacity withholding.

Review

This paper offers a rigorous examination of the impact of vertical integration on market outcomes in wholesale electricity auctions. Utilizing a two-stage game-theoretic model, the authors characterize how vertical integration influences price equilibria and firms' incentives for strategic capacity withholding. A key finding, aligning with empirical observations in electricity markets, is that firms' strategic behavior is dictated by their net demand position. Crucially, the analysis concludes that, for the majority of parameter values, a vertically integrated market structure actually fosters a greater occurrence of competitive pricing in the wholesale market. The most significant contribution of this work lies in its surprising assertion that vertical integration eliminates incentives for strategic capacity withholding. This finding directly challenges recent analyses and conventional wisdom often critical of vertical integration, suggesting that such structures might unexpectedly mitigate certain forms of market manipulation. By providing a clear theoretical framework for these dynamics, the paper offers a robust counter-narrative, indicating that integration could potentially serve as a mechanism to reduce anti-competitive behavior in electricity markets. Overall, this paper provides valuable insights into the complex interplay between market structure and firm behavior in wholesale electricity markets. Its counter-intuitive findings regarding the pro-competitive effects of vertical integration on pricing and the elimination of strategic capacity withholding are particularly noteworthy. This work makes a significant contribution to the literature, prompting a reconsideration of traditional assumptions and offering important implications for policymakers involved in electricity market design and regulation.

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