Strategic bidding in vertically integrated power markets with an application to the Italian electricity auctions

In this paper we apply a model of optimal bidding behavior to the Italian wholesale electricity market under three hypotheses: i) costs of generation are private knowledge, ii) firms can be vertically integrated, and iii) firms can sell part of their production in advance with bilateral contracts. We first use optimal bid functions and market data to retrieve time-varying marginal cost functions, price-cost margins and Lerner Indexes of market power for a sample of Italian companies. Then, we use estimated costs and actual equilibrium prices to evaluate the elasticity of these series to fuel price variations and estimate a possible differential impact of the dynamics of input expenditures (fuel price above all) on generation costs and final electricity prices. Our estimates suggest that the elasticities of costs and equilibrium prices with respect to oil price are virtually the same and, therefore, that the auction mechanism per se does not limit the extent to which cost increases are transferred to prices. © 2011 Elsevier B.V.