Center for the Study of Energy Markets

While studies have found substantial inefficiencies in some restructured electricity markets, this paper demonstrates two reasons why performance is relatively competitive in the Pennsylvania, New Jersey, and Maryland market. First, in this market, the vertical integration of firms reduces electricity producers’ interest in setting high prices: producers sell into the wholesale market and also are required to buy in the market in order to provide power to their retail customers at set rates. Second, I account for production constraints that result in cost non-convexities. When ignoring these constraints, measures of price-cost margins—which are based on a method common to the literature—imply that market imperfections during the summer following restructuring increased procurement costs 51% ($950 million). This method further implies considerable welfare loss as actual production costs exceeded the competitive model’s estimates by 12.5%. This paper develops a consistent estimate of competitive production decisions and predicts that costs were only 3.4% above competitive levels. Using this method of estimating production, I compare behavior of two producers that have relatively few retail customers with other firms. Consistent with these vertically integrated firms’ incentives, only firms with large net selling positions in the market reduced output relative to competitive production estimates.