De Centralizing Hydropower Production

Decentralizing hydro power production
Stefan Ambec INRA-GAEL, University of Grenoble

Joseph A. Doucet School of Business, University of Alberta
Abstract. We analyse the production of electricity from n power stations in a dynamic

model. Each power stations production of electricity is constrained by the quantity of
water available to it (supply constraint) as well as limitations on reservoir capacity
(storage constraint). We show that hydro power production can lead to two sources of
welfare loss: suboptimal management of water resources and the exercise of market
power. A monopolist minimizes the first source of inefficiency, whereas decentralized
production in a competitive environment minimizes the second. The decision to introduce competition in hydropower production must account for these two opposite
effects. JEL Classification: L11, Q48
Decentralisation de la production dhydroelectricite. Nous analysons la production
dhydroelectricite par n centrales dans un mode`le dynamique. La production de chaque
centrale est contrainte par la quantite deau disponible (contrainte dapprovisionnement) et la capacite du reservoir (contrainte de stockage). Nous demontrons que la
production hydroelectrique peut donner lieu a` deux types dinefficacite: la gestion sousoptimale des ressources hydrauliques et lexercice de pouvoir de marche. Lentreprise
monopolistique minimise la premie`re inefficacite alors que la production decentralisee
dans un marche concurrentiel minimise la deuxie`me. La decision dintroduire la concurrence dans la production dhydroelectricite doit tenir compte de ces deux effets
opposes.
1. Introduction
This paper is motivated by two phenomena that are of great importance for
many regulators around the world: electricity-restructuring initiatives and
water resource management related to hydroelectricity generation. While
restructuring initiatives generally emphasize the introduction of competition
in the generation segment of the industry and hence call upon decentralized
We thank Bernard Lamond for helpful discussions on hydroelectric systems, as well as Bob
Cairns, Gerard Gaudet, Stephane Lemarie, and Francois Salanie for useful comments. All
errors remain our responsibility. Ambecs research was supported by GREEN (Universite
Laval) and the European Commission under the RTN Program HPRN-CT-2000-00064.
Email: ambec@grenoble.inra.fr
Canadian Journal of Economics / Revue canadienne dEconomique, Vol. 36, No. 3
August / aout 2003. Printed in Canada / Imprime au Canada
0008-4085 / 03 / 587607 /
Canadian Economics Association
588
S. Ambec and J.A. Doucet
market mechanisms, water resource management within a river system

with hydroelectric production often leads to some form of centralized
decision-making because of the externalities involved in water flows and
water management decisions. It would thus appear, and such has been the
perceived wisdom, that river systems with multiple hydroelectric plants
are not amenable to competition between plants. The intuition is that the
increase in social welfare resulting from competition in the electricity market
is more than offset by a decrease in social welfare from inefficient management
of the water.1
Important hydroelectric systems can be found throughout the world. For
instance, in Quebec 94% of the provinces electricity production capacity is
hydro. What is more, this production capacity is fairly concentrated: 74% is
situated in three major river systems and 89% in six river systems.2 It has long
been argued that ownership of sites along a river cannot be separated. Further,
since capacity is highly concentrated in a small number of river systems,
introduction of an efficient market mechanism has been deemed infeasible
for Quebec.3 In essence, the intuition is that the benefit due to coordinated
management of water, both along and between rivers, outweighs the potential
gain in efficiency that would be obtained from greater competition in the
electricity market.4
A second example closely related to the issue under discussion comes from
California. Under Californias electricity restructuring plan, Pacific Gas and
Electric (PG&E), one of the states three public utilities, proposed to sell the
3,900 megawatts (MW) of hydroelectric capacity that it owns. PG&Es proposed sale offered the capacity in 20 different groups, which it referred to as
bundles. The bundles are made up of plants, equipment, and water rights
along particular rivers or river systems. Environmental analysis of the proposed sale suggests that a change in ownership might lead to changes in the
timing of release of water, which could change levels of reservoirs. In addition,
1 Note that costs associated with the inefficiency are multifaceted and can be environmental
(related to river flows, habitat, recreational value, etc.) as well as economic (related to the
optimal use of water, from an economic perspective). In this paper we simplify the problem by
dealing only with the latter costs. Extending the costs to other types of impacts would not
change the models results qualitatively.
2 Source: Hydro-Quebec Web site: http://www.hydroquebec.com/
3 As voiced by Raphals and Dunsky (1997): The vast majority of Hydro-Quebecs production
comes from hydroelectric complexes, each of which is composed of many plants situated
along the same hydrographic system. These complexes must therefore be managed in an
integrated manner, since otherwise the management of an upstream plant could induce negative
impacts on the management of downstream plants. In a competitive market, day to day
management issues and the possibility of market power for an upstream plant would become
even more important (33; our translation).
4 Note that hydro systems generally have relatively low electricity costs, which in turn reduces the
scope for important efficiency gains from competition. This fact also bolsters the argument in
favour of centralized control.
589
analysis by an administrative law judge has raised concerns that the change in
ownership might lead to market power.5
These are but two examples. Hydro exists in important sizes elsewhere, such
as Norway, New Zealand, and Brazil. Furthermore, it is often state owned.
For this reason examination and understanding of issues related to competition, as markets evolve to more competitive forms, is relevant to policy makers.
In small number of papers the issue of strategic competition in electricity
markets is addressed. Scott and Read (1996) model the optimization of hydro
reservoir operation in a deregulated market with both hydro and thermal
capacity. Along the same lines, Crampes and Moreaux (2001) study competition
between a thermal power producer and a hydro power producer. Bushnell
(1998) quantifies the inherent advantages that hydro can have in a competitive
market because of storage. He focuses on the electricity market of the western
United States and explicitly addresses strategic behaviour of players. Along the
same theme, namely, hydro-thermal complementarities, Von-der-Fehr and
Sandsbraten (1997) analyse the gains from trade in electricity. They focus on
how the technological complementarities present in electricity may lead to gains
from trade that are different from those traditionally associated with comparative advantages and economies of scale. Closest in spirit to our paper are Garcia,
Reitzes, and Stacchetti (2001), who focus on understanding the dynamic strategic
behaviour of two hydro producers. While they limit their analysis to two producers of equal size facing a perfectly inelastic demand, they derive interesting results
regarding the impact of strategic behaviour on system parameters, the impact of
price caps, and the likelihood of collusion. They take a positive approach, asking
what a duopoly in hydro power production would lead to, and do not address
any policy issue. We go one step further by asking if this competitive outcome is
indeed more efficient than the previous monopoly situation.6
What is particular about hydroelectricity and distinguishes it from competing sources, especially thermal, is that markets do not really exist for water,
hydroelectricitys key input. Transportation of water between different rivers is
prohibitively costly and is quite simply impossible in the short term. This is the
crux, or driver, of our paper. In a broad sense, our focus is on clarifying the
impact on welfare, under diametrically opposed market conditions, of the
absence of markets for water. In order to do this, we decompose the welfare
loss (compared with the first best) into two separate effects, the water
5 Information on the proposed sale can be found at the California Public Utility Commission
site: http://cpuc-pgehydro.support.net/. Although still under some discussion, the sale appears
to be moot for the moment. On 18 January 2001 California Governor Davis signed into law
Assembly Bill 6, which states that no facility for the generation of electricity owned by a public
utility may be disposed of prior to January 1, 2006.
6 For this purpose, we enrich the model by introducing an arbitrary number of plants and
heterogeneity across plants. This allows us to link policy recommendations to particular hydro
systems. For simplicity, we drop the assumption of random water inflows. We briefly conjecture
how random water inflows would affect our results in the conclusion.
590
management effect and the market power effect. In doing so we are able to
clearly distinguish, in terms of welfare, between the coordinated approach of
the monopoly and the decentralized decision-making in competition.
Our results suggest that competition can, but need not always, be superior
to monopoly. More important, we suggest directions (reasons) related to
physical parameters of systems that point in one way or the other. This
could provide policy makers with numerical/empirical tests to evaluate the
wisdom of particular forms of organization and control.
To be precise, the absence of a market for water need not be, by itself, the
reason for inefficiency of competitive hydro power production. Indeed, an
input for hydro power can be defined by water at a specific location, so that
electricity is produced by as many inputs as there are hydro plants with convex
production sets. In this framework, the First Welfare Theorem should apply.
Here, we deviate from the assumption underlying the First Welfare Theorem
by assuming imperfect competition in the electricity market. Thus, imperfect
competition and the absence of a market for water are two ingredients for
inefficiency of competitive hydro power production. Moreover, we stress that,
with a competitive market for water and imperfect competition in electricity
production, decentralized hydro power production would be efficient.
The rest of the paper proceeds as follows. We present the underlying model
in section 2. In order to derive the intuition, in section 3 we solve the model for
the simple case of a monopolist, first with a single plant, then extended to n
plants. The case of competition with n firms is then solved in section 4. In
section 5 we compare the monopolistic and competitive results, providing an
explicit decomposition of welfare into water management and market power
effects. In section 6 we provide illustrative examples of the two polar opposites,
efficient and inefficient decentralization. Finally, section 7 concludes with a
discussion of some relevant policy issues.
2. The model
Consider a dynamic model with two periods of production.7 Let denote the
discount factor between periods. The inverse demand for electricity during
period t, denoted Pt for t 1, 2, is assumed linear.8 Formally, for any arbitrary
Qt, Pt (Qt) at btQt with at > 0 and bt > 0.9
7 Two periods are sufficient in order to highlight the dynamic nature of the problem and the implicit
link between decision periods that storage capacity creates. In addition, the practice of management
of hydro systems usually focuses on some element of a peak versus off-peak problem, and in this sense
a two-period model is appropriate. As such, the proposed model is sufficiently general to capture
either seasonal or shorter-term storage problems (daily, weekly), but not both simultaneously.
8 This assumption is used only for the proof of the lemma. Propositions 1 and 2 rely on the more
general assumptions Pt0 and Pt00 Qt 2Pt0 < 0, which guarantee that the profit of the monopoly
is strictly concave and therefore avoids uninteresting corner solutions.
9 In general, of course, the two demands, peak and off-peak, are different.
591
Electricity is produced from n hydro power plants (n > 0). It is assumed that
each plant i 2 N is located on a different river.10 Plant i produces qit units of
electricity during period t by using water flowing to it. For simplicity, it is
assumed that one unit of water used at Plant i yields i units of electricity
(i > 0).11 Operating costs are normalized to zero. It is assumed that the unit
cost of producing more electricity than there is available water is infinite. The
total production of electricity during period t is Qt i2N qit.
There are natural inflows of water: eit denotes the exogenous (perfectly
forecasted) volume of water supplied in the hydrographic basin controlled by
Plant i during period t, and ei1 ei2 denotes the total volume of natural water
inflows at site i during the two periods. It is assumed that water is scarce
enough not to be wasted. In other words, over the two periods each Plant i uses
all of the water inflows to produce electricity up to its two-period production
capacity qi:12
qi1 qi2 qi i (ei1 ei2 ):
(1)
This implies that total production during the two periods equals total production
:
capacity (i.e., available water) of the system Q
X
X

Q1 Q2 Q
i (ei1 ei2 ):
(2)
qi
i2N
i2N
Water available to i during period 1 can be used to produce electricity

during the first period or can be stored in is reservoir for use in the second
period. In the first period, Plant i relies on water in its hydrographic basin (i.e.,
no water is available from the previous period). Hence, it is able to produce at
no cost during the first period any quantity qi1 such that
qi1 i ei1 :
(3)
10 The case of plants located along the same river is studied in our working paper, Ambec and
Doucet (2001). The analysis highlights similar water management and competition effects.
11 i is a productivity parameter that is exogenous and constant in the current setting. In practice, its
value can and does vary as a function of system parameters, most notably the water head (height
of the water fall from the intake to the turbines). However, this quite simple linear production
function mapping water releases to power production is consistent with Wood and Wollenbergs
(1996) statement that flow of 1 ft3 falling 100 ft has the power equivalent of approximately
8.5 kW. . . The power equivalent for a flow of 1 ft3 of water per second with a net drop of 100 5,
or 95 ft, would have the power equivalent of slightly more than 8 kW (8.5 95%).
12 Assuming that producers exhaust their inflows of water over the two periods obviously
simplifies the problem. However, on average in a long-term equilibrium, hydro plants cannot
have net positive or negative accumulation of water. The assumption reflects this physical
limitation. Alternatively, we can suppose that market demand is such that the marginal revenue
of electricity is always positive, which implies no incentive to produce less than the maximum
capacity. Modifying this assumption to allow for wastage of water does not qualitatively
change the results. Lastly, one can imagine that the regulator prohibits wastage of water.
592
Equation (3) represents Plant is (first-period) supply constraint, in effect,

the upper bound on first-period production.13
The volume of water stored in is reservoir during the first period, ei1 (qi1/
i), is used in its entirety to produce electricity in the second period. (Recall
that no water is wasted.) This volume is bounded by the reservoir capacity,
denoted si (which is, without loss of generality, assumed to be strictly positive).
In terms of first-period production, this storage constraint is written
qi1 i (ei1 si ):
(4)
Constraint (4) states that water that is not stored in the first period must be
used to produce electricity. The upper bound on storage yields a lower bound
on first-period electricity production.
A production plan is any vector q (q1 ,q2 ) 2 Rn Rn , where qt (q1t, . . .,
qit, . . ., qnt) for each period t 1, 2, which satisfies equations (1), (3), (4) for
every i 2 N.
3. Monopoly
3.1. Monopoly with a single plant
We first solve the monopolists problem, assuming that it has access to only
one hydro plant, say Plant 1. A monopoly production plan
m
Qm (Qm
maximizes the monopolys total profit
1 ,Q2 ) 2 R R
(Q1,Q2) 1(Q1) 2(Q2) P1(Q1)Q1 P2(Q2)Q2. Since constraint (1)
uniquely determines the second-period production level Qm
2 , only the firstperiod production level Qm
needs
to
be
characterized.
The
monopoly
produc1
tion plan Qm can be found by solving,
Q1 ), subject to
maxQ1 1 (Q1 ) 2 (Q
Q1 1 e11
Q1 1 (e11 s1 ):
Denoting m and m the Langrangian multipliers associated with, respectively,
the upper-bound constraint (the supply constraint) and the lower-bound constraint (the storage constraint), the first-order conditions yield
m
0
m
m
01 (Qm
1 ) 2 (Q2 ) ,
m (Qm
1 1 e11 ) 0:
m
(1 (e12 s1 ) Qm
1 ) 0:
13 Note that it is implicitly assumed that Plant i possesses the technology (i.e., the turbines) to use
this quantity of water. As such, there is no upper limit on the production capacity other than (3).
593
Substituting the demand function Pt for t 1, 2, the first-order conditions

imply
m
m
m
m0 m
m
m
Pm0
1 Q1 P1 (P2 Q2 P2 )
(5)
Equation (5) captures the monopolys choice between first- and second-period
production. As usual, the monopoly seeks to equalize marginal revenues to
marginal costs. Because operating costs are assumed to be zero, the monopoly
is really looking at the opportunity cost of water usage in each period, which
itself is a function of electricity production. The cost of one more unit produced today is one less unit to be produced tomorrow. Hence, the marginal
cost of producing today is equal to the marginal loss of tomorrows revenues
evaluated today. Equation (5) tells us that, whenever it is possible (i.e., when
neither the supply nor the storage constraint is binding), the monopoly
equalizes marginal revenues. However, this production plan may not be
feasible because of supply or storage constraints. When this is the case, the
multiplier associated with the binding constraint m or m is strictly positive.14
The multiplier in question represents the shadow cost of the constraint, the
scarcity of water during one period: multiplier m (m ) increases as the firstperiod (second-period) supply of water decreases. Hence, it is always true that
marginal revenues, net of the shadow costs of the constraints, are equalized
(a` la Hotelling).
For example, suppose that the first-period supply of water e11 is not high
enough to allow the profit-maximizing monopolist to set production such that
marginal revenues are equalized across periods. In this case the monopolist
turbines water up to its supply constraint, thereby producing Qm (1e11,
1e12). As a result, m > 0. In this case the first-period marginal revenue, net
of the shadow cost of the supply constraint m , equalizes the second-period
marginal revenue in todays dollars. Symmetrically, it may be that the storage
capacity s1 is not large enough to equalize marginal revenues across periods.
Put differently, the second-period water capacity may not be high enough to
equalize marginal revenues, given the storage capacity. In this case the monopoly binds its storage constraint (or second-period supply constraint). It stores
up to its capacity and produces Qm (1(e11 s1), 1(e12 s1)). In this case
m > 0. Once again, the first-period marginal revenue equalizes the secondperiod marginal revenue in todays dollars net of the shadow cost of the
storage constraint m .
To sum up, three mutually exclusive outcomes are possible: (1) no constraints bind, in which case water is managed to equalize marginal revenues; (2)
the supply constraint binds, in which case all first period water supply is used
during the first period; and (3) the storage constraint binds, in which case
14 Notice that as long as the plant has a reservoir of non-zero size and some storage is possible, the
two constraints cannot simultaneously bind.
594
first-period water is stored up to the storage capacity and is used to produce

electricity during the second period.
3.2. Monopoly with n plants
Suppose, now, that the monopolist owns n > 1 production plants. In this case,
in addition to choosing how much electricity to market in each period, the
monopolist also decides how to allocate total production between its plants. It
chooses a production plan qm that meets its aggregate production goal Qm.
Because second-period production is defined by constraint 1, the monopoly
n
n
m
production plan qm (qm
1 , q2 ) 2 R R can be found by solving
Q1 ), subject to
maxq1 1 (Q1 ) 2 (Q
X
q
Q1
i2N i1
qi1 i ei1
qi1 i (ei1
si )
for every i 2 N:
The maximization program is now subject to n supply constraints and n

storage constraints. The variable of choice q1 is now of dimension n. Denoting
m
m
i and i the Langrangian multipliers associated with, respectively, the supply
constraint and the storage constraint on qi1 for every i 2 N and substituting the
first constraint into the objective function, the first-order conditions yield
0
m
m
m
01 (Qm
1 ) 2 (Q2 ) i i ,
m
m
(q i ei1 ) 0,
i
i1
i ) qm
m
i (i (ei1 s
i1 ) 0, for every i 2 N:
Substituting the demand function Pt for t 1, 2, the first-order conditions imply
m
m
m0 m
m
m
m
Pm0
1 Q1 P1 i (P2 Q2 P2 ) i , for every i 2 N:
(6)
Again, the monopoly equalizes marginal revenues across periods net of the
shadow costs of the constraints.
From the first-order conditions, we can say more about the monopoly
outcome. First, just as in the single plant case, because si > 0, it cannot be
the case that both is supply and storage constraints bind simultaneously. This
is true for every i 2 N. Second, it cannot be the case that plant is supply
constraint binds while plant js capacity constraint binds (for j 6 i). If this were
the case, the monopoly could release both constraints by decreasing q1i and
m
m
m
increasing q1j. Third, the first-order conditions imply m
i i j j for
every i, j 2 N. These three remarks, taken together, imply that if m
i > 0, then
m > 0 and m m 0 for every i, j 2 N. Symmetrically, if m > 0,
m

j
i
j
i
i
m
m
m
then m
j i > 0 and j i 0 for every i, j 2 N. This result is summarized in words in the following proposition.
595
1. Three mutually exclusive outcomes are possible: (1) no constraints

bind; (2) all capacity constraints bind; and (3) all storage constraints bind.
PROPOSITION
Proposition 1 suggests that the monopoly outcome does not change qualitatively when the monopolist owns more than one plant. The monopolist uses
its hydro park like a bigger single plant through appropriate management of
water. We will now show that expanding the set of hydro plants does affect the
monopolists profits. It is exactly like an increase in the plants water supply or
storage capacity.
m
Proposition 1 allows us to simplify the notation. Let us denote m
i and i
m
m
m
m
m
for any arbitrary i 2 N, respectively, and . Define . The
first-order conditions imply
0
m
m
01 (Qm
1 ) 2 (Q2 ) :
(7)
Since the multi-plant monopolist manages water in order to equalize its

marginal revenue across periods, an increase in the number of plants increases
total profit by way of improving the coordination opportunities. This is
formalized in the following proposition.
PROPOSITION
2. jm j weakly decreases as N expands.
Proof. See appendix A.

The monopolist reduces the shadow costs of the constraints by a suitable
coordination of production across plants. With more plants, it simply has
better coordination opportunities. In particular, if the first-period water supply
is not high enough to equalize marginal profits, it binds all plants capacity
constraints, turbines all first-period water supply, and produces
Qm (i2Niei1, i2Niei2). All supply constraint shadow costs m
i are strictly
positive and equal to, say, m . As the monopolist increases the number of
plants, say, to n 1, the first-period water supply increases by e(n1)1. This
additional amount of water available for first-period production reduces the
shadow cost of all supply constraints and consequently increases the monopolists profit. Symmetrically, if the (aggregate) storage capacity (or the secondperiod water supply) is not high enough to equalize marginal profits, as the
monopoly increases the number of plants, the storage capacity and the secondperiod water supply increase, which reduces the shadow cost of all storage
constraints and, finally, increases the monopolys profit.
4. Competition
Suppose, now, that each plant is owned by an individual firm, Firm i being the
owner of plant i. In each period the n firms compete in quantity in a single
596
electricity market. Consider the following game. At the beginning of the first
period, the firms observe the future water supply eit at every i 2 N and t 1, 2.
Then, at each stage t 1, 2 of the game, firms simultaneously choose their
production level qit 2 R . We derive the perfect subgame equilibria of this
game.
In this game, the strategy of player i is defined by a vector of production
levels qi (qi1, qi2). As usual, (qi1, qi2) denotes the strategies of the other
players and the sum of these strategies Qit j6i qjt for every t 2 {t = 1, 2}.
Player is payoff is the discounted sum of his per period profits
P1(qi1 Qi1)qi1 P2(qi2 Qi2)qi2 for i 2 N.
Because it is assumed that all water is used in the two periods,15 first-period
production entirely determines second-period production. Hence, each firm
has only one strategic decision variable, second-period productions being a
residual. Therefore, using 1, the second-period equilibrium strategy for each
firm i 2 N is defined by
qî2 qi qi1 ,
(8)
During the first period, Firm i maximizes its two-period profit, subject to its
first-period supply and storage constraints and given the strategy Qi1 of the
other players and the anticipated second-period best replies. Firm is firstperiod program is thus
î2 )^
qi2 Q
qi2 , subject to
maxqi1 P1 (qi1 Qi1 )qi1 P2 (^
qi1 i ei1
qi1 i (ei1 si ):
Denoting ci and ci the Langrangian multipliers associated with, respectively,
the upper-bound constraint (supply) and the lower-bound constraint (storage)
on qi1, the first order conditions yield,
"
!
#
î2
î2
dQ
c0 c
c
c0 c
c dq
P1 qi1 P1 P2 qi2 1
ci ci ,
P2
dqi2
dqi1
ci (qci1 i ei1 ) 0,
ci (i (ei1 si ) qci1 ) 0, for every i 2 N:
î2 =dqi2 0. Therefore, the firstEquation (8) implies d qî2 =dqi1 1 and d Q
order conditions imply
Pc01 qci1 Pc1 ci (Pc02 qci2 Pc2 ) ci :
(9)
15 Clearly, this is the case in a subgame Nash equilibrium of our finite repeated game: as long as
marginal profits are positive in the second period, each firm will produce up to its capacity.
597
Each firm equalizes marginal revenues on its residual demand, net of

the shadow costs of the constraints. Summing up (9) for all firms i 2 N, we
obtain
Pc01 Qc1 nPc1
X
i2N
ci (Pc02 Qc2 nPc2 )
ci :
(10)
i2N
Equation (10) is an aggregated equilibrium condition that allows us to

compare the competitive outcome with the monopoly outcome.
5. Comparison of the monopoly and the competitive outcomes
We now compare the performance of the two outcomes with respect to welfare,
where welfare W is defined by the discounted sum of total surplus for all
periods.16 The welfare resulting from any arbitrary aggregate production
level Q (Q1, Q2) is W(Q1, Q2) w1(Q1) w2(Q2), where, for t 1, 2,
Qt
wt (Qt )
Pt (X)dX:
0
To simplify the comparison, we establish the following lemma.

For any two production plans Qa and Qb, jPa1 Pa2 j < jPb1 Pb2 j if and
only if W(Qa) > W(Qb).
LEMMA.
Proof. The formal proof is presented in appendix B.

The intuition of the proof can be explained graphically in figure 1. Figure 1
represents the inverse demand functions for the two periods on the same graph.
The first-period (off-peak) and second-period (peak) prices are, respectively,
on the left axis and the right axis. The length of the horizontal axis is equal to
(a function of the total supply of water).
the total capacity of production Q
Take any point on this axis. The distance from the left (right) represents
the first- (second-) period consumption level. The welfare induced by
Qa (Qa1 , Qa2 ) is the sum of the area below P1(Q1) from 0 to Qa1 and the area
Qa ) from Qa to Q
.
below P2 (Q
1
1
The first-best allocation, when feasible, divides the total production capacity at O, where the two demand functions cross. Discounted prices are equal
at this point, and more electricity is produced and consumed during the peak
period. This choice maximizes the welfare represented by the area under the
curve AOB. Any other division of Q induces a dead-weight loss of welfare. For
16 The period
P t total surplus sums the consumers surplus
surplus i2N Pt (Qt )qt Pt (Qt )Qt .
R Qt
0
Pt (X)dX Pt (Qt )Qt and the firms
598
P1
P2
A
O
Q1
Q1
FIGURE 1
instance, the loss of welfare induced by the production level Qa is represented

by the shaded area. We argue that this welfare loss increases with the (discounted) price gap and vice-versa. This is obviously true when increasing the
price gap moves the first-period production to the left of Qa1 (i.e., Qa1 decreases).
It is also true when the original first-period production level is to the right of
Q*1 , and increasing the price gap moves first-period production further to the
right. With linear inverse demands, as assumed here, the price gap and the
welfare loss are symmetric with respect to Q*1 .
We now compare the two market outcomes using the lemma. Let us denote
ci ci ci and write (6) and (10), respectively,
. for the monopoly outcome:
m
m
m0 m
m0 m
Pm
1 P2 [P1 Q1 P2 Q2 ]
.
(11)
for the competitive outcome:

Pc1 Pc2
1X
1
ci [Pc01 Qc1 Pc02 Qc2 ]:
n i2N
n
(12)
The left-hand side in (11) and (12) quantifies the performance of the market
outcome with respect to welfare: the closer to zero the price gap, the higher is
the welfare. The right-hand side explicitly decomposes the loss into two
terms. The first term is the water management effect. For the monopoly
outcome, the absolute value of this effect decreases as the monopoly owns
more plants (proposition 2), indicating that the monopoly minimizes this term
through coordinated water management. For the competitive outcome, introducing more competition with more plants has an ambiguous effect on this
term. (In the next section we provide examples for positive and negative
599
effects.) Of course, this term is nil when no (supply or storage) constraints are
binding.17
The second term on the right-hand side of (11) and (12) is the standard
market power effect. For the monopolist this loss of welfare is due to the fact
that the firms interests do not coincide with those of the consumers. This term
tends to zero as n goes to infinity in the competitive outcome. To summarize,
we have established the following proposition.
3. Hydro power production can lead to two sources of inefficiency and welfare loss: suboptimal management of water resources and the
exercise of market power. A monopolist minimizes the first source of inefficiency,
whereas decentralized production in a competitive environment minimizes the
second.
PROPOSITION
Before closing this section and moving to an illustrative example, it is

instructive to explain the inefficiency of decentralized hydropower production
in terms of the absence of a market for water. It is precisely because water
cannot be purchased and transported at low cost, like other inputs, that
competition sometimes does worse than monopoly. To see this, suppose, on
the contrary, that water can be exchange during period t 1, 2 at a price pt > 0.
Consider the example of section 6.3. Since 1 unit of water produces i units of
electricity for i 1, 2, the benefit of purchasing one unit of water during period
2 is the marginal revenue induced by this additional input net of the shadow
cost of the storage constraint, if it is binding. With a market, each firm will buy
(sell) water as long as the equilibrium price p2 is lower (higher) than this
benefit. In the example, therefore, Firm 2 would sell water to Firm 1, thereby
reducing the shadow cost of the binding storage constraint. Indeed, Firm 1s
second-period supply constraint (or its first-period storage constraint) is
relaxed by the amount of water it purchases. At the equilibrium of the water
market, benefits for water purchased are equal. Suppose, to simplify, that the
two firms are equally productive, meaning that 1 2. Then, at the equilibrium, marginal revenues will be equal across plants and periods. By selling
water, Firm 2 relaxes Firm 1s constraint, thereby minimizing the water management effect.
17 For the case of linear demand considered here, this happens when the unconstrained
competitive production plan qc defined by
1 a1 a2
b2
qi , and
qci1
1 n b1 b2 b1 b2
qci2
1 a2 a1
b1
qi ,
1 n b1 b2 b1 b2
for every plant i 2 N is such that parameters are such that qci1 i ei1 and qci1 i (ei1 si ) for
every i 2 N.
600
6. An illustrative example
As an illustrative example, we consider an economy composed of two plants
and characterized by the following parameters: a2 > a1 (period 1 is off peak and
period 2 is peak), b1 b2 b (both demands have the same slope), e12 e22 0
(all water inflows occur in period 1, the off peak) and, 1 (indifference
between periods in terms of payoff).
The above parameters conceptually fit the situation in many hydroelectric
systems (such as those of Quebec, British Columbia, the U.S. Pacific Northwest, and Scandinavia), where water inflows arrive (principally) in the off-peak
season (spring-summer) as a result of winter runoff. Formally, they imply
1e11 2e21.
qi iei1 for every i 2 N and Q
For these parameters, we first analyse the monopoly outcome. Then we
study decentralization of hydro power production with both a case of Pareto
improvement and a case of reduction.
6.1. Monopoly
Suppose, first, that supply and storage constraints are not binding; that is,
m
m
i i 0 for every i 2 N. For these parameters, (6) with multipliers nil
becomes
m
a1 2bQm
1 a2 2bQ2 :
Substituting (2), we obtain the unconstrained aggregate outputs

m

Qm
1 (a1 a2 )=4b Q=2 and Q2 (a2 a1 )=4b Q=2.
In general, only lack of storage capacity will cause the above production
levels not to be feasible. Typically, since all water inflows arrive in period 1,
while demand is higher in period 2, the supply constraints will never be
binding: Water supply is always high enough to cover first-period production.
However, reservoir capacities could be too low to achieve the above aggregate
production allocation. In other words, the storage constraints could bind. This
/2 (a2 a1)/4b. The analysis is illustrated in
happens when 1
s 1 2
s2 < Q
figure 2.
The thin lines represent marginal revenues for the two periods. They cross at
at Qm . When possible,
point M, which divides the total production capacity Q
1
m

the monopoly equalizes marginal revenues and produces (Qm
1 , Q Q1 ). It fixes
the peak-period price above the first-best price (and the off-peak-period price
below) to extract more surplus, thereby inducing a deadweight loss. However,
these production levels might not be feasible because of insufficient reservoir
capacity. For instance, suppose that the storage capacity is such that at most
in figure 2 can be produced during the second period (i.e.,
the distance AQ
). In this case the monopoly
suppose that 1
s1 2
s2 equals to the distance AQ
at
stores up to its storage capacity, thereby dividing its production capacity Q
A. The resulting peak-period price is even higher reflecting water scarcity
601
P2
P1
M
0
Q1
Q1mA
FIGURE 2
relative to the demand for electricity. In this case, the monopoly outcome (i.e.,
A) is efficient in that it is the feasible allocation closest to Q*. The shadow cost
of the storage constraint is strictly positive, so that the monopolys first-period
marginal revenue is lower than the discounted second-period marginal revenue.18 Notice that if the supply constraints bind (which is never the case here,
but would be the case, for example, if most water inflow arrives during the
second period), the monopoly outcome can be more efficient as it moves
production closer to Qm
1 (i.e., the price gap decreases). If the shortage of
first-period water supply is so high that the monopoly first-period production
is to the left of Q*1 , then the monopolys outcome is inefficient, whereas the
first-best unconstrained outcome is feasible.
6.2. Efficient decentralization
Suppose first that supply and storage constraints are not binding. For these
parameters, take 10 with multipliers nil and divide each side by n to obtain
1
1
a1 bQc1 a2 bQc2 :
n
n
(13)
Equation (13) is an equilibrium condition represented in figure 3.

The left-hand (right-hand) side of (13) is drawn from the left-hand (righthand) axis in a dashed line. Each line lies between the inverse demand function
18 Notice that, as long as it is positive (which is the case at A), the monopoly does not restrict its
first-period production. Otherwise, when storages constraint forces first-period marginal
revenue to be negative, the monopoly would equalizes it to zero, thereby wasting water to
restrict its first-period supply whenever it is possible.
602
P2
.....
.
...
...
.....
...
...
.....
.
...
...
.....
..
...
....
.. ..
.
.... O
..
....
...
....
...
.
.
.
....
.... ......
...C
........
.. ..
..... .......
..... M ......
.
....
...
....
...
....
.....
...
.
0
Q
P1
FIGURE 3
(Pt(Qt) at bQt) (thick line) and the monopoly marginal revenue function
(0t (Qt ) at 2bQt ) (thin line). The competitive outcome splits total capacity
Q, where the two dotted lines cross, namely, point C. Since C is located
between O and M with respect to the horizontal axis, the competitive price
gap lies between the first-best nil price gap and the monopoly price gap. Thus,
the competitive outcome increases total welfare compared with the monopoly
outcome. Moreover, as n increases, the slope of each line decreases, and
therefore C gets closer to O. Thus the competitive outcome becomes more
efficient.
To be precise, combining 13 and 2 yields the aggregate production outcome
Qc
( a 3b a Q2 , a 3b a Q2 ):

1
Firm is equilibrium production is obtained by substituting the assumed parameters in 9 and 1 to get
qci1
a1 a2 qi
a2 a1 qi
and qci2
for i 1, 2:
6b
2
6b
2
This unconstrained production plan can be achieved for parameters such

that
a1 a2
a1 a2
i ei1 i si
for i 1, 2:
3b
3b
The above is the expected result of competition. As the example of the next
section shows, operational constraints can result in competitions actually
doing worse than the monopoly outcome.

P1
...
...
...
...
...
...
...
...
...
...
...
...
...
...
O .....
...
...
...
...
...
...
C
...
...
... M
...
...
.
...
1(e11 s1)
c
Q1
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
...
603
P2
1s1
FIGURE 4
6.3. Inefficient decentralization

Suppose that Firm 1s storage constraint is binding, meaning that
s1 < e11 [(a2 a1)/3b1], while Firm 2s constraints are not binding. Then
Firm 1 stores up to its reservoir capacity to produce qc12 1 s1 . Its remaining
first-period water supply is devoted to first-period production
qc11 1 (e11 s1 ). Firm 2, which is unconstrained, can therefore act as a
monopoly on the residual demand. As a monopolist, it equalizes marginal
revenues on this residual demand, thereby producing qc2 (qc21 , qc22 ) such that
s1 ) 2bqc21 a2 b1
s1 2bqc22 :
a1 b1 (e11
(14)
Substituting 1 into 14 yields

a1 a2 1 e11 1 s1 q2
and
4b
4
2
2
a2 a1 1 e11 1 s1 q2

:
4b
4
2
2
qc21
qc22
The above analysis is illustrated in figure 4.

Firm 1 produces up to the left (right) vertical dashed line in the first (second)
period starting form the left (right) vertical axis. Firm 2 acts as a monopoly on
the residual demand in the centre of the graph. It equalizes marginal revenues
represented in the dotted lines. Firm 2s production divides its production
capacity q2 (i.e., the distance between the two dashed vertical lines) where
these two dotted lines cross, namely, point C. Going back to the complete
between first- and
graph, C also splits the aggregate production capacity Q
second-period aggregate production, respectively, Qc1 and Qc2 . In the above
example, C is located further away from O than is M (with respect to the
604
horizontal axis), implying that the competitive price gap is higher than the
monopoly price gap. Put differently, the competitive outcome decreases total
welfare compared with the monopoly outcome. This case happens when Plant
1s storage capacity
s1 is low enough (
s1 < e11/4), and Plant 2s storage capacity

s2 is high enough to achieve the monopoly unconstrained outcome
a2 a1 1 e11 e21 1

(
s2
s1 ),
4b2
22
2
2
and Firm 2s unconstrained outcome
a2 a1 1 e11 e21
(
s2
):
4b2
42
2
Though a simple case, this example illustrates how introducing more competition can increase or decrease the water management effect. To explain this
further, suppose first that only Firm 2 provides electricity to the market. It can
equalize marginal revenues and achieve the monopoly solution without binding its constraints. Hence, its multipliers are nil and so is the water management effect. Now, introducing Firm 1, with a small reservoir, will actually
increase the value of this term which becomes strictly positive.19 Firm 2
essentially acts as a monopolist on a smaller market, which, as a result, reduces
welfare.
Alternatively, suppose now that only Firm 1 supplies electricity. It binds its
storage constraint to serve the peak period demand as widely as possible.
Introducing Firm 2 into the market renders the second-period demand less
attractive, thereby reducing the shadow cost of Firm 1s storage constraint
and, finally, the water management effect.
7. Policy issues
The introduction of competition in hydro systems is almost always controversial, for a host of economic, social, and environmental reasons. As such, policy
makers need a firm grasp of the issues and a clear understanding of the stakes
involved in order to be able to make wise decisions.
This paper clarifies the trade-offs arising in the management and use of
water and reservoir capacity in the light of competitive electricity markets.
Though the intuition behind the basic trade-offs is usually well understood,
our explicit formulation and resolution of the problem suggest more clearly
what decision makers should be looking at. Specifically, our results point to
the possibility of a quantitative analysis of the costs and benefits of competition between different hydro plants. More important, our analysis suggests a
19 It may be more exact to note that we are really talking about splitting the existing capacity
between firms.
605
useful decomposition of the welfare loss (vis-a`-vis the first best) into two
distinct parts attributable to water use and to market power. This in turn
points out that a decentralized decision must depend on the specific hydro
configuration and parameters in question. In particular, regulators must
account for, and in some cases weigh and compare, the impacts on water
management and on electricity market competition of their decisions.
One could imagine situations where such an analysis would be of great
benefit. For instance, in an electricity market where appropriate levels of
competition exist, because of structural remedies, interregional trade, or
other reasons, it might be found that the value of coordinated reservoir
management far exceeds any potential competitive benefits in the electricity
market. Alternatively, analysis of the hydrological data (water inflows, etc.)
and reservoir characteristics might indicate that the benefits of coordination
are, in fact, very small and less than the value of increased competition. For
instance, in the case of Pacific Gas and Electrics assets in California, it might
be preferable, from a market power perspective, not to bundle plants along the
same river. The cost of this, in terms of reduced coordination of water use,
might be more than offset by the increased competition induced along the
river. In the current context of Californias electricity market, increased competition in the generation market would certainly be welcome.
Secondly, our results suggest that regulators need to account for the impact
that their policies may have on decentralized production. As mentioned in the
introduction, policies governing water management often attempt to account
for a variety of environmental costs and benefits, as well as alternative water
uses.20 Water release policies, which are often operationalized as constraints on
minimal or maximal flows (e.g., Bushnell 1998 and Edwards, Flaim, and
Howitt 1999, for formal analysis), obviously have an impact on the value of
water. This translates in our model into additional supply or storage constraints. This impact, in the context of a particular electricity market, could
be significant and relevant for the evaluation of the decentralization decision.
For instance, suppose that in section 6.2s numerical example, Firm 1 imposed
a lower bound on its first-period releases (or equivalently, an upper bound on
its second-period releases). This regulation constrains Firm 1s first-period
production. If this bound is low enough, the competitive outcome may be
inefficient, as it is in section 6.3.
Thirdly, further investments on the existing hydro installations may have
non-trivial effects on decentralized production and its welfare properties.
Similar to a change in regulation, investment may modify the constraints.
Diverting a river to supply a plant relaxes the supply and/or storage by
increasing input supply. An increase in a plants storage capacity relaxes its
storage constraint. When this extra storage capacity is used, the decentralization
20 For example, Chatterjee, Howitt, and Sexton (1998) highlight conflicting joint provision of
water for irrigation and hydropower.
606
outcome changes. If applied to Firm 1 in section 6.3s numerical example, this

investment increases the welfare and can render decentralized hydro power
efficient.
Finally, decentralization of production often goes hand in hand with an
opening of markets to new outside competitors. Our model suggests that the
welfare benefits resulting from an increase in the number of competitors could
depend, at least in part, on the complementarity of the different producers
water and reservoir parameters. Once again, the underlying issue is the absence
of markets for water and the impacts that this has on intertemporal water
management and on electricity production.
Appendix A: Proof of proposition 2

Consider two set of plants Na and Nb such that Na Nb, their respective
optimal monopoly production plans, qma and qmb and, monopoly outputs
Qma and Qmb. Suppose that the proposition is not true. Then, given 7, we have:
0
ma
0
mb
0
mb
j01 (Qma
1 ) 2 (Q2 )j < j1 (Q1 ) 2 (Q2 )j:
(A1)
Since t is concave for t 1, 2 and since both Qma and Qmb satisfy 2, then (A1)
implies (Qma) < (Qmb). However, because Nb contains Na, Qma can be
produced with the set of plants Nb. Therefore, the last inequality contradicts
&
the fact that qmb is an optimal monopoly production plan.
Appendix B: Proof of lemma
First, notice that W(Q1, Q2) is maximized at (Q*1 , Q*2 ) such that that the price
gap is nil:
P1 (Q*1 ) P2 (Q*2 ):
(B1)
yields 16 as the firstIndeed, maximizing W(Q1, Q2) subject to Q1 Q2 Q

order condition. Or, put differently, (Q*1 , Q*2 ) is defined as the unique solution
] to R as
to 16 and 2. Second, define the function mapping [0, Q
Q1) for any Q1 2 [0, Q
]. Third, define the function
(Q1) P1(Q1) P2(Q
] to R as L(Q1 ) W(Q* ; Q* ) W(Q1 , Q
Q1 )
welfare loss L mapping [0, Q
1
2
(the shaded area in figure 1). Straightforward computation yields
Q*
1
L(Q1 )
(X)dX:
(B2)
Q1
Now, for any production plans qa and qb, W(Qa) > W(Qb ) () L(Qa1 ) < L(Qb1 ).
Thus, all we need to show is the following claim: for any production plans qa
and qb, j(Qa1 )j < j(Qb1 )j if and only if L(Qa1 ) < L(Qb1 ).
607
First, both j (Q1) j and L(Q1) are decreasing on [0, Q*1 ] and increasing on
]. Therefore, for any Qa and Qb such that Qa 2 [0, Q* ] and Qb 2 [0, Q* ],
Q
1
1
1
1
a
j(Q1 )j < j(Qb1 )j () Qa1 > Qb1 () L(Qa1 ) < L(Qb1 ). Symmetrically, if Qa1 2
] and Qb 2 [Q* , Q
], then j(Qa )j < j(Qb )j () Qa < Qb () L(Qa )
[Q*1 , Q
1
1
1
1
1
1
1
b
< L(Q1 ). Second, consider the other cases. First, notice that with linear
demand functions as assumed here, both j (Q1) j and L(Q1) are symmetric
],
with respect to Q*1 in the precise sense that, for any Qa1 2 [0, Q
a
*
a
a
*
a
j(Q1 )j j(2Q1 Q1 )j and L(Q1 ) L(2Q1 Q1 ). Consider first the
]. Since both 2Q* Qa and Qb
case Qa1 2 [0, Q*1 ] and Qb1 2 [Q*1 , Q
1
1
1
*
belong to [Q1 , Q], then, as previously established, j(2Q*1 Qa1 )j <
j(Qb1 )j () L(2Q*1 Qa1 ) < L(Qb1 ). The last equations imply j(Qa1 )j <
] and Qb 2 [0, Q* ] is
j(Qb1 )j () L(Qa1 ) < L(Qb1 ). The case Qa1 2 [Q*1 , Q
1
1
&
similar.
[Q*1 ,
References
Ambec, S., and J.A. Doucet (2001) Competition along a river: decentralizing hydropower production, Working Paper 56, CSEF, University of Salerno
Bushnell, J. (1998) Water and power: hydroelectric resources in the era of competition
in the western U.S., POWER Working Paper PWP-056r, POWER, University of
California Energy Institute, Berkeley
Chatterjee, B., R.E. Howitt, and R.J. Sexton (1998) The optimal joint provision of
water for irrigation and hydropower, Journal of Environmental Economics and
Management 36, 295313
Crampes, C., and M. Moreaux (2001) Water resources and power generation, International Journal of Industrial Organization 19, 97597
Edwards, B.K., S.J. Flaim, and R.E. Howitt (1999) Optimal provision of hydroelectric
power under environmental and regulatory constraints, Land Economics 75, 26783
Garcia, A., J.D. Reitzes, and E. Stacchetti (2001) Strategic pricing when electricity is
storable, Journal of Regulatory Economics 20, 22347
Raphals, P., and P. Dunsky (1997) Ouverture des marches de lelectricite au quebec :
options, imperatifs dune relle concurrence et consequences pour les prix, mimeo,
HELIOS Centre, Montreal
Scott, T.J., and E.G. Read (1996) Modelling hydro reservoir operation in a deregulated
electricity market, International Transactions in Operational Research 3, 24353
Von der Fehr, N.H.M., and L. Standsbraten (1997) Water on fire: gains from electricity
trade, Scandinavian Journal of Economics 99, 28197
Wood, A.J., and B.F. Wollenberg (1996) Power Generation, Operation, and Control
(New York: John Wiley)

De Centralizing Hydropower Production

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

De Centralizing Hydropower Production

Uploaded by

Copyright:

Available Formats

Decentralizing hydro power production

Stefan Ambec INRA-GAEL, University of Grenoble

Abstract. We analyse the production of electricity from n power stations in a dynamic

Canadian Economics Association

S. Ambec and J.A. Doucet

market mechanisms, water resource management within a river system