A model-based analysis of strategic consolidation in the German electricity industry

When Germany liberalised its electricity market in April 1998, wholesale and heavy industry prices fell by as much as 60%. This was initially seen around the world as a success story in electricity market liberalisation as it involved a minimum of institutional interference. However, this approach may have become a victim of its own success. Facing a significant fall in profits, the largest generators adopted a strategic response with three sequential phases: (i) cut costs so as to be able to lower prices and maximise market share to deter entry, (ii) seek regulatory approval to acquire or merge with rivals to create four dominant vertically integrated firms, and (iii) close marginal plant to reduce overcapacity. Using a model-based simulation approach that has previously been successfully applied to strategic behaviour in the UK electricity market, this paper demonstrates that the process of strategic consolidation could result in average annual on-peak prices rising by 87% and average annual off-peak prices by 50%. Furthermore, the impact of an increase in industry concentration would be magnified as generators’ close their marginal plant. The creation of four dominant firms, who have the discretion to strategically withdraw capacity, appears to result in a substantial increase in market power in the wholesale electricity market and hence a significant rise in prices above the competitive levels that initially emerged.