Economists have devoted a great deal of attention to market power in electric power markets in the somewhat general, structural sense, but very little of that work focuses much attention on networked-nature of the industry. The network matters a lot – that’s one of the views well articulated in the Thomas, et al., paper mentioned here last week – and it is the networked nature of the industry that accounts for the emergence of the institution of market monitoring in the integrated power markets.
The Federal Energy Regulatory Commission is hosting a technical conference April 5 to “explore the effectiveness of market monitoring both in performing market oversight and in serving a variety of interested stakeholders.” In a recent notice, FERC listed several questions it wanted panelists to address. The fourth question is where things really get interesting….
Before I go any further, I should mention that I am employed – as of a few months ago – by a company involved in electric power market monitoring. You are warned that I may be biased, but also note that I blog in my spare time, and nothing I say here should be taken to be the position of my employer. Now back to the posting:
It isn’t that the first three questions FERC asks don’t have their value – these questions, about the interaction between market monitors and the Commission, and aiming at how the market monitors can help the Commission in its job, have a good deal of practical significance to the Commission. Under the law, the Commission has a job to do, and the market monitors can help the Commission do that job more efficiently. But it is the fourth question that begins to open things up and seek to understand why some industries might support market monitoring functions and others don’t.
In question 4, FERC asks, “Are there other industries that are subject to comparable monitoring activities, and, if so, how are these activities structured?”
Yes, there are other industries also subject to monitoring. But before the examples, here is the foundation: The network matters a lot.
My thinking here is guided by the excellent paper by Amitai Aviram, “Regulation by Networks” (published in the BYU Law Review, but a version is available online as a U. of Chicago Law working paper). Aviram points out that the function of regulatory institutions in the broad sense is to mitigate opportunistic behavior in economic transactions. Networked industries can be particularly resilient to certain kinds of opportunistic behavior such as fraud, for example, because the network itself naturally collects information about transactions in the course of matching buyers and sellers. If a party doesn’t pay or doesn’t deliver after being paid, the network can block them from further transactions. On the other hand, networks are vulnerable to strategies like degradation that non-network industries don’t face. Aviram has much more. Even in networked industries, buyers/sellers and government have valuable regulatory roles to play, but in a networked industry the network itself can play a key role.
The short version of the role of market monitors in power markets is this: Regional electric power markets integrated with regional transmission operations help create a great deal of economic surplus when they run well. However, even in cases in which the transmission network is well developed, it is likely that some suppliers will have significant market power under regularly recurring conditions. Exercising market power in these cases constitutes opportunistic behavior in Aviram’s sense – acting to gain a larger portion of the economic surplus available through use of the network in a way that reduces the overall size of the surplus created. To the extent that the network can detect and deter attempts to exercise market power before they play out in the market, the better the networked industry will work. To some extent good market design can diminish opportunities for the exercise of market power, but transaction-level monitoring and market power mitigation remains a value-creating proposition by the network.
The examples in other industries don’t all look quite like market monitoring in electric power, but the other networks don’t exactly look like centrally-dispatched transmission grids either. Aviram’s piece helps draw the connection. In most of these cases, the network collects information as part of its natural functions (or easy extensions thereof), and the information is used to discourage or block opportunistic transactions. As a result, the networked industry is more productive.
Consider, for example, telephone networks. Many people are interconnected through networks, and the value created by “transactions” (i.e. phone calls) is immense. Some commercial entities seek to exploit this great interconnectivity among people in an effort to gain additional surplus, but which diminishes the overall size of the surplus created (i.e., the marketer’s phone call during dinner). The FTC’s “Do Not Call” list and Caller ID both work to deter this kind of opportunistic behavior. For example, caller ID passes information along to the end consumer which helps consumers reject opportunistic calls.
The internet/email/spam example is similar: email provides great economic value to users, spammers exploit that value in ways that reduce substantially the overall value of email, and internet service companies seek help their customers block spam, in some cases exploiting their roles as networks to detect spam and trace it to its sources.
Credit card networks also exploit their central information processing position to detect and deter fraud. Sophisticated algorithms can identify unusual patterns or unlikely purchases and either refuse a transaction or, at least, generate a call to the cardholder to verify a purchase. Also, a consumer who defaults by not paying his credit card bill not only will lose that particular credit card, but risks losing access to other credit cards. Individual stores are not in a position to know, absent their connection to the credit card network, which consumers presenting a credit card are good risks and which are not.
Stock exchanges and futures exchanges also conduct monitoring operations. Access to information that the exchanges themselves collect in the ordinary course of business – for example, the flow of orders from various parties – can be examined to reveal front running, market timing offenses, and other activities that floor specialists, brokers and other market insiders can abuse opportunistically to extract value from decentralized buyers and sellers. By deterring opportunistic behavior, the network encourages participation in the market by a larger number of people, and increasing the number of people participating multiplies the value-creation possibilities.
There is more to market power mitigation in networks than sketched here. For example, (warning: naked self interest alert) the above only touches on market power monitoring in integrated power markets, but on similar grounds the energy imbalance markets managed by large, vertically-integrated electric utilities could benefit from market monitoring. But the above discussion captures the key function of market monitors, the reason for the emergence of the institution: detection and mitigation of attempts to exploit transitory market power.