Pricing Decisions and Market Power in the UK Electricity Market: A VECM Approach

Abstract

This paper examines the influence of market power in the formation of retail and wholesale electricity prices in the UK over 1998–2012 on the basis of Vector Error Correction model (VECM). Market power is measured as the influence of the market share of the Big Six in a dynamic demand and supply VECM. The findings indicate that market power of the Big Six in the wholesale industry has a significant and large positive influence on the wholesale mark-up in the short-run. The long-run estimates support the arguments about ‘revenue rebalancing’ resulting from vertical integration. That is, low market power (and hence low revenues) in the wholesale industry leads to higher prices (hence higher revenues) in the retail industry. These findings are in contrast to the CMA's finding that no market power is exercised in the wholesale industry. Retail electricity prices are affected directly by both the wholesale and retail market concentration ratios in the long-run rather than indirectly through the wholesale mark-up. Overall, the findings in this paper provide support for the view that the UK electricity market exhibits significant anti-competitive conduct in both the retail and wholesale segments.