Vertical Integration and Fuel Diversity in Electricity Generation – a theoretical study in imperfect competition

This paper contains an analysis of stylised natural gas and electricity supply sectors. Power plants operate either on natural gas or on a competing fuel – e.g. oil. The competing fuel is assumed to be traded at world market price whereas natural gas is sold by a national monopoly. The paper conducts a number of analyses using different market structures, ranging from perfect competition, over oligopolistic competition among power plants using natural gas only, to situations with both gas and oil and vertical integration in the natural gas part of the sector. The paper provides a number of results, some of which are quite surprising: (1) The natural gas monopoly price is only vaguely correlated with the oil price although the fuels are competing; (2) A merger between the gas supplier and a gas-fired power plant is likely to increase social welfare, and consumer surplus; and (3) Competition between fuels has more positive effect on social welfare than increased competition between gas-fired plants.