The properties of the power market are closely linked to storage of energy. If electricity could be stored inexpensively like ordinary goods the production structure and the market would be much different. There would be one or a few types of thermal power plants operating at near full capacity all the time. The system marginal cost function would be nearly flat. There would be little room for market power since new producers could easily enter to share excess profits if incumbent producers tried to exercise their market power.
Because in reality storage of electricity is expensive and consumption varies over time the optimal production structure is a mixture of different production technologies with diverse capital and operating costs. The result is a production system with rising marginal cost depending on which type of production is needed on the margin to meet demand at a certain moment. From a competition point of view there is, unlike other types of markets, not one homogenous market but several separate markets. Each type of power in a marginal cost range constitutes a separate market with possibilities to exert market power.
The availability of storage is, therefore, of key importance when assessing market power in the electricity market. With ample storage the electricity will function more like an ordinary market. With little storage the conditions may be very different from ordinary commodity markets.
Another feature of today’s deregulated electricity markets is the use of auction systems to organize sales and purchases. From a competition point of view auction markets can have quite different properties compared to other models for competition, for instance the Cournot model.
A third feature of the electricity market is the degree of contestability. There is relatively ease of entry of new producers threatening incumbent producers if they charge high prices.
A fourth feature of the electricity market is its transparency, especially where auction systems are used. Typically hourly auction prices and aggregate quantities are published. It may even be possible to get information on bid functions. Production plant properties are also often well known since there are rather few standard production technologies with well known operating costs. Therefore, electricity markets are ideally suited to test different theories.
The purpose of this paper is to give a comprehensive treatment of the electricity market with storage, i.e. hydro power, with an auction market organisation and to test the models on the Nordic market in order to explore the explanatory power of auction market theory and the theory of contestable market. The main theoretical effort in the paper concerns auction theory with inventories.
The paper develops an inter-temporal auction model of a thermal-hydro power market. Parallel to the derivation of the basic equations a numerical model is developed in order to illustrate the results of the model.
Section 2 summarizes the basic equations for an inter temporal auction thermal-hydro market. Section 3 contains the illustrations of solutions to equations for some stylized markets. In section 4 the auction model is tested on the Nordic market.