Did electricity companies really overcharge by $4.3b? Part 1

I finally have a bit of spare time from my day job to post my thoughts on why I don’t believe the Wolak report’s claim of overcharging by $4.3b over 7 years. The way that the overcharging figure was calculated is a bit involved, but it essentially boils down to an assumption that it would have been possible to supply the country’s electricity needs, even in periods of low hydro reserves, if all generators (hydro or thermal) had charged the marginal operating cost of the most expensive thermal plant. This is shown in the following graph taken from the Wolak report which compares the actual wholesale price to that theoretical benchmark.

The counterfactual prices (in red) rise a bit in the winter months, as marginal costs are higher at thermal plants when they operate close to full capacity, but not by as much as actual prices (in blue), particularly in the dry years of 2001 and 2003.

There are underlying assumptions here that I question. The first is that the marginal operating cost rather than capacity constraints would have been the key determinant of prices in a competitive market. The report assumes that since plants were operating below full capacity during the dry years, the high prices were not due to capacity constraints, but this ignores that fact that plants are required to maintain capacity in reserve so that the system does not collapse if there is a failure at some point in the transmission grid (so called ancillary reserves), and also that hydro generators in particular, need to conserve the limited amount of water in their reservoirs at the start of the winter months not only for later use at the time when, in retrospect, it has the highest value (the report’s assumption), but also as insurance against continuing low inflows. That is, even if in retrospect at the end of a winter it transpires that not all the available water was used, that does not mean that reserves were being strategically withheld to manipulate price; it is consistent with the need to maintain security of supply for all but the worst-case contingencies.

The second underlying (and implicit) assumption in the report is that the electricity demand is fully inelastic (i.e. unresponsive to price). More on that in the next post.