Monday, January 09, 2006

Analysing Strategic Behaviour in Wholesale Electricity Markets

A computer model called CustomBid and written by William Chapman in Visual C++. can be used to answer broad questions about strategic behaviour by electrical generator owners in wholesale electricity markets like:

  • How much market power is there in this market?
  • Will prices collapse if the largest player divests its assets?
  • What is the best portfolio of plants to have in this market?
  • What level of contract cover will frustrate strategic behaviour by a particular player?

Unlike a production cost model, where technical constraints determine prices and payoffs, CustomBid concentrates on the strategic determinants. In a production cost model the implicit assumption has always been that participants’ bids reflect underlying short-run marginal costs as determined by technology, fuel costs etc. In practice we observe that participants’ bids do not reflect costs: indeed, were they always to do so, few players would recover their full costs. On the other hand, players do not explicitly collude so as to achieve prices that guarantee full recovery of their costs. Explicit collusion is often difficult to sustain because of the incentive to cheat by participants; it is also prohibited. Instead, participants are subject to varying degrees of competition. In general, the more competitive the market the closer participants’ bids come to their underlying short-run marginal costs.

To answer these questions the model makes use of Game Theory. Game Theory was developed shortly after the Second World War as a way of analysing strategic interaction between players whose actions impact one another. The software model is free downloadable from the header link.

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