Market Power and Liquidity in SEM A report for the CER and the Utility Regulator 15 December 2010 Prepared by: Cambridge Economic Policy Associates Ltd 1 ŀ Contents Executive summary ............................................................................................................. 4 Introduction ............................................................................................................................................ 4 Overview of mitigation measures and scenario analysis ................................................................... 4 Review of market power mitigation strategy ...................................................................................... 5 Liquidity ................................................................................................................................................... 6 Policy options and recommendations ................................................................................................. 6 Conclusion ............................................................................................................................................... 8 1. Introduction ................................................................................................................. 9 1.1. Interactions with other work undertake by the Regulator Authorities ............................. 9 1.2. Structure of report .................................................................................................................... 9 2. Objectives and criteria ................................................................................................ 11 2.1. Introduction ............................................................................................................................. 11 2.2. Objectives of the Market Power Mitigation Strategy ........................................................ 12 3. Assessing market power ............................................................................................. 14 3.1. Introduction ............................................................................................................................. 14 3.2. Defining market power as a concept ................................................................................... 14 3.3. Market Power in Electricity ................................................................................................... 15 3.4. Measures of market power in electricity .............................................................................. 16 3.5. Market power and access to information ............................................................................ 18 3.6. Evolution of market power in the SEM .............................................................................. 19 3.7. Evolution of profitability in the SEM.................................................................................. 19 3.8. Analysis of RSI in the SEM ................................................................................................... 22 3.9. Conclusion ............................................................................................................................... 28 4. Assessment of the market power mitigation measures ............................................. 30 4.1. Introduction ............................................................................................................................. 30 4.2. Design of the current Market Power Mitigation Strategy ................................................. 31 4.3. Bidding code of practice, and monitoring by the Market Monitoring Unit ................... 32 4.4. Directed Contracts.................................................................................................................. 33 4.5. Ring Fencing ............................................................................................................................ 36 4.6. Economic purchasing obligation .......................................................................................... 37 4.7. Wider observations on the domestic retail market ............................................................ 39 4.8. ESB’s proposal to re-integrate .............................................................................................. 40 4.9. Conclusions on market power mitigation measures .......................................................... 42 2 5. Contract Liquidity in the SEM .................................................................................. 43 5.1. Introduction ............................................................................................................................. 43 5.2. Contract liquidity as a concept .............................................................................................. 43 5.3. Key features of liquidity and measures ................................................................................ 44 5.4. Current state of contract liquidity in the SEM ................................................................... 46 5.5. Drivers of liquidity .................................................................................................................. 49 5.6. Outlook for liquidity .............................................................................................................. 56 5.7. Potential issue of market power in the market for contracts ........................................... 59 5.8. Effect of interconnectors arrangements .............................................................................. 62 5.9. Role of information ................................................................................................................ 63 5.10. International experience of liquidity .................................................................................... 65 5.11. ESB’s liquidity Proposals ....................................................................................................... 69 5.12. Summary on liquidity ............................................................................................................. 70 6. Policy options ............................................................................................................. 72 6.1. Introduction ............................................................................................................................. 72 6.2. Assessment of current mitigants .......................................................................................... 73 6.3. Structural changes in the SEM .............................................................................................. 74 6.4. No removal of ring-fencing between ESB Group companies ......................................... 75 6.5. Horizontal ring-fencing between ESB Group generating companies relaxed or removed ................................................................................................................................................. 81 6.6. Horizontal and vertical integration of ESB allowed .......................................................... 84 Annex 1: Summary of responses to State of the Nation Review ........................................ 91 Annex 2: Summary of terms of reference for Day Ahead Trading work .......................... 106 Annex 3: Scenario metrics ................................................................................................ 108 Annex 4: RSI curves .......................................................................................................... 109 Annex 5: ESB’s proposals ................................................................................................. 115 Annex 6: Modelling assumptions ..................................................................................... 154 Annex 7: Consultation questions ...................................................................................... 157 3 EXECUTIVE SUMMARY Introduction This report has been prepared by Cambridge Economic Policy Associates Ltd (CEPA) and assesses the evolution of competition in the SEM, the appropriateness of the current market mitigation strategy and the outlook for contract market liquidity. As such, the report builds on the analysis presented by the Regulatory Authorities (‘RAs’) in the August 2010 paper “SEM Market Power and Liquidity State of the Nation Review” (‘the State of the Nation Review’) 1 and the responses to that publication. The RAs have also asked CEPA to consider ESB’s proposals regarding horizontal and vertical reintegration and the associated liquidity undertakings. The SEM, in its design as a gross mandatory pool, has limited potential for spot market power. However, at its inception, given the dominant positions of ESB and Viridian, the RAs decided to put in place a package of mitigants to prevent abuse of market power and to encourage competition in the wholesale market. The package included the Bidding Code of Practice (‘BCoP’), the Market Monitoring Unit (‘MMU’), Directed Contracts (‘DCs’) and the Economic Purchasing Obligations (‘EPO’), as well as measures to address local market power where needed. Overview of mitigation measures and scenario analysis The market design and the associated mitigation measures appear to be working well. Reserve margins are high, although in part due to falling demand, and our examination of (falling) profitability in the SEM does not point to any abuse of market power – although some