Transmission capacity effects on market inefficiencies in the California electrical network

This paper empirically investigates the welfare performance of the California wholesale electricity market from April 1998 through December 2000. We focus on market power and productive inefficiency to measure this deregulated market's performance. We build our empirical analysis on Wolfram (1999), Borenstein, Bushnell and Wolak (2002) and Joskow and Kahn(2002), that calculate the competitive benchmark price to meet aggregate market demand in the absence of network constraints. The California market data shows that transmission congestion segments market. Finite transmission capacity may not allow inframarginal plants to produce their full capacities and the competitive benchmark prices in the presence of transmission capacity constraints are different across partitioned markets. The constrained competitive benchmark price could be different from the competitive benchmark price in the absence of transmission capacity constraints, and the discrepancy between market price and the competitive benchmark price in the absence of the transmission capacity constraints is not totally due to market power. In contrast to existing studies, we explicitly consider transmission capacity constraints in our analysis. Based on Cho(2002), we characterize the competitive equilibrium price and quantity considering transmission capacity constraints in the California electrical network. Taking into account transmission capacity constraints significantly reduces the estimated magnitudes of market power and productive inefficiency. We show that the previous estimate could overstate market power more than 20% during the sample period. The efficiency loss due to finite transmission capacity count for 10–40% of the total welfare loss. Some congestion arises from efficient allocation in the presence of transmission capacity constraints as efficient plants attempt to deliver power to zones with less efficient plants.