4 - Identification and Estimation of Cost Functions Using Observed Bid Data: An Application to Electricity Markets

Summary

INTRODUCTION

This paper presents several techniques for recovering cost function estimates for electricity generation from a model of optimal bidding behavior in a competitive electricity market. These procedures are applied to actual data from the Australian National Electricity Market (NEM1) to recover cost function estimates for a specific market participant. I find close agreement between the cost functions recovered from these procedures and those obtained from engineering estimates. The techniques developed in this paper for recovering cost function estimates are not limited to markets for electricity generation. They can be used to recover cost function estimates for a participant in any bid-based centralized market.

There are number of uses for the procedures developed in this paper. The primary use is to measure the extent of market power possessed by a market participant using only bid information and market-clearing prices and quantities. A major research effort in empirical industrial organization is the measurement of market power. Bresnahan (1989) summarizes much of this research, although there has been an explosion of recent research on this general topic. The techniques presented in this paper are a logical extension of the techniques described by Bresnahan (1989) to bid-based markets.

A major challenge for designers of competitive electricity markets is to devise market rules that limit the ability of generation unit owners to exercise market power. Market power is the ability of a firm owning generation assets to raise the market price by its bidding behavior and to profit from this price increase.