Abstract:

Deregulation of the frequency response market in the UK allowed electricity firms to compete on price in an otherwise stable environment. We provide an analysis of the evolution of the deregulated market from the date it started. Initial activity was volatile, with some firms exploring different prices, while others made few price changes. This was followed by a period in which prices fell and the variance in the cross sec- tional distribution of bids declined markedly. By the end of our study price changes had became relatively rare and small, consistent with convergence to a static Nash equilibrium. We examine how well models of learning do in predicting play during the period prior to convergence but after the initial volatility. Models where perceptions of competitors’ play depend on past play suggest that firms’ weight recent play dispro- portionately. We also find evidence of statistical learning about the underlying demand parameters conditional on competitors’ play. A model that combines these two features fits quite well: it is able to explain 37% of the share-weighted variation in prices, even though none of the model parameters are chosen to fit the pricing behavior.