Environmental Regulation in Oligopoly Markets: A Study of Electricity Restructuring

Electricity restructuring o®ers the potential for more e±cient production and investment, but may create the opportunity for producers to exercise market power. Oligopolists may cause deadweight loss in wholesale electricity markets, even when demand is perfectly inelastic, by inducing cross̄rm production ine±ciencies. This study estimates the environmental implications of production ine±ciencies attributed to market power in the Pennsylvania, New Jersey, and Maryland electricity market. Air pollution fell substantially during 1999, the year in which both electricity restructuring and new environmental regulation took e®ect. I measure production ine±ciencies by comparing observed behavior with estimates of production in a competitive market. During the period studied, actual production costs, including abatement costs, exceeded competitive estimates by 8%. Estimates of competitive production, which account for new environmental regulation, explain only 60% of the observed pollution reductions. The remaining 40% can be attributed to ̄rms exercising market power. Given oligopoly behavior in product markets, I discuss the conditions under which environmental policy makers improve welfare with permit systems in comparison to pollution taxes. JEL Classi ̄cation: H23, L11, L94 ¤Ph.D. Candidate, Department of Economics, U.C. Berkeley and University of California Energy Institute. e-mail: [email protected]. I thank Alan Auerbach, Peter Berck, Severin Borenstein, Jim Bushnell, Stephen Holland, Aviv Nevo, Steve Puller, Celeste Saravia, and Catherine Wolfram for useful comments, and the California Public Utilities Commission and the University of California Energy Institute for ̄nancial support.