Price-capping in partially monopolistic electricity markets with an application to Italy

In many electricity markets the production capacity of a single supplier may be necessary to satisfy the total demand even when its competitors offer their total capacity. These pivotal suppliers are expected to sell at monopolistic prices on their portions of the market demand. In this paper, we show that these market conditions may imply the non-concavity in prices of the pivotal supply function, which in turn means that there can be situations in which a pivotal operator's supply has virtually no price limits. We also show that this monopolistic market power can be significantly reduced by vertical integration and/or regulatory policies such as virtual power plants. Based on these results, we propose a simple price-capping rule that induces the pivotal operator to compete for quantity instead of taking advantage of its monopoly. Then, we infer the profit function of the Italian pivotal operator (Enel) for the sample period 2007-2010 using real auction data and cost curves employed by engineers. We discuss the bidding behaviour of Enel and show how its profit function varies over time and in response to pro-competitive measures introduced during our sample period. We examine the existing price-cap and propose an alternative mechanism. © 2012 Elsevier Ltd. All rights reserved.