A study on the deregulation of the Finnish electricity markets

Abstract Governments have regarded the electricity industry as a leading industrial sector throughout the history. Because of its strategic importance to industrial development, its impacts on the social and environmental issues and its natural monopoly characteristics, it has been seen necessary to regulate electricity industry effectively. However, in the mid 1980s it was realised that even though transmission and distribution networks are natural monopolies, the scale economies in electricity production at the generating unit level had exhausted at a unit size of about 500 MW. This meant that supply and generation had become potentially competitive activities. In Finland the new Electricity Market Act (EMA) came into force in 1.11.1995. According to it the production and supply of electricity became deregulated and competition was introduced to the industry. The main aim of the law was to improve efficiency. This dissertation analyses, both theoretically and empirically, the impacts of deregulation to the Finnish electricity markets. In chapter two we discuss on the grounds and incentives of the deregulation processes that have been carried out in different countries. We also determine the crucial factors in order succeed in the deregulation process. According to our view the success depend on the number of active players in the wholesale market, the rules of the bidding procedure, the organisation of the demand side operation, the neutrality of transmission grid, the structure of production technologies and the ownership structure of the industry. In chapter three we theoretically model the profit maximising behaviour of the Finnish electricity companies based on different stages of vertical integration and on different stage of competition. According to our results the profit maximising pricing rules of distribution units is dependent on the stage of integration and on the stage of competition. The separated distribution company maximises profits by setting the distribution price equal to the long-run marginal costs plus mark-up determined by price elasticity of demand. The integrated distribution unit has to take also the impacts on the supply unit into account when setting the distribution price. Chapter four considers the consequences of deregulation to the wholesale price of electricity and the market structure of the industry. It is interesting to question whether deregulation in some circumstances may lead to higher prices instead of lower ones. The relationship between the Cournot equilibrium on the one hand and Bertrand equilibrium on the other will be quantitatively explored. The results indicate that deregulation can result in a significant price increase and output decrease in Finland if there occurs Cournot type of competition. In chapter five we consider alternative pricing policies for a regulated distribution company and empirically analyse is it possible to achieve welfare improvements by changing the prevalent price structure to the more efficient one. We use four different pricing methods which are marginal cost pricing, fully distributed cost pricing (FDC), Ramsey pricing and optimal two-part tariffs. The results indicate that it is possible to improve welfare quite markedly by switching from the existing pricing principles to more efficient ones. The resulting welfare is highest if we use the first best prices based on marginal costs or optimal two-part tariffs