Power Engineering - Datamonitor report sees broader benefits of energy liberalization

22 September 2004 - Despite the considerable anecdotal evidence suggesting that energy competition has been bad for residential customers in the UK, Datamonitor's Daniel Legg argues that an analysis of the benefits of market liberalization needs to look beyond residential retail prices. Indeed, a liberalized residential market is an important component of a fully functioning liberal I&C market.

Some breathtaking recent price rises have led industry watchers to ask whether electricity market liberalization has benefited customers, and a report from the University of Sussex claims that the cost of introducing competition has outweighed any savings made by consumers.

Although the benefits of residential market liberalization are diffuse and complex, it can be argued that there are benefits even in the narrow economic sense of prices. There are three components that make up the retail price for electricity paid by residential consumers: generation costs, transmission and distribution costs, and supply costs. We need to look at them separately when we evaluate the connection between liberalization and price movements.

The introduction of competition into electricity markets brought about a precipitous drop in wholesale prices, much to the detriment of British Energy and the merchant generators. This in turn can be attributed to three factors:

1. The profit motive induces generators to optimize their fuel mix, both in short term decisions on how to produce peak load, and in long term decisions concerning new build.

2. Fuel procurement practices: generators procure fuel as efficiently as possible, not allowing ambiguous considerations like 'the national interest' to influence their decisions.

3. Generators build and manage their assets as efficiently as possible. Importantly, they are encouraged to retire inefficient plants rather than run them at a loss. Unfortunately for the free market argument, this arguably is achieved at the expense of security of supply.

Although the above factors tended to force both wholesale and retail prices down in the UK after the introduction of the New Electricity Trading Arrangements (NETA), prices could not remain depressed forever. But this does not mean that the above factors ceased to apply - the current rise in wholesale prices can be attributed to a reduction in capacity and, most importantly, a rise in commodity fuel prices. Liberalization of the wholesale market cannot terminate the cyclical nature of commodity fuel prices; but it should train utilities to adjust to such cycles in the most efficient way possible.

A second factor in the reduction in retail energy prices has been the reduction in transmission and distribution prices. Ofgem has achieved this in the UK by pegging permitted access charges to the performance of the most efficient network operators, thus encouraging the remaining players to improve performance if they are to make a return. However, it is fair to acknowledge that all of this could have been possible without competition - distribution companies are still regulated monopolies.

The third component of retail prices - supply costs - in fact rose with the advent of competition. In short, suppliers chasing customers suddenly had to cover sales and marketing costs that had never been an issue before. However, this need not be a permanent characteristic of the market. The reduction of 14 UK electricity boards to six large energy retailers certainly resulted in synergy savings; and suppliers made great strides in reducing their internal process costs, although none of this outweighed the high cost of acquiring new customers.

However, frenetic switching in the UK residential market was followed by a period of relative calm, with most suppliers concentrating on controlling costs, partly by slashing their sales and marketing budgets. An industry-wide initiative to improve the switching process should result in a further reduction in costs, and also do a lot to assuage customer dissatisfaction.

We do not have to be too kind to UK suppliers though: their notoriety is mostly deserved. However, the costs of introducing competition and of rectifying mis-selling scandals are not supposed to be eternal; the economic benefits will last.

The benefits of liberalization are not simply price related. There are several positive consequences of a consumer's ability to choose, and the symmetrical ability of energy suppliers to acquire new customers. One of the most important is the rapid development of new energy and energy related products.

Liberalization implies that utilities can expand beyond their core product, enabling them to increase profits by selling extra services to their existing customer base. It also allows them to drop prices to consumers by bundling products. This expansion of services will allow the development of a whole concept of 'services for the home' encompassing appliances, insurance, energy saving products as well as the basic utility services.

As well as product innovation, the need to differentiate products and to meet customer needs has led to a multiplication of tariff structures in an effort to suit varied segments of the residential market. There are now online tariffs for people who are prepared to be proactive in return for lower prices, green tariffs for the environmentally concerned, a flat tariff for the elderly, various levels of standing charge, capped tariffs for the cautious, and affinity deals for those who want to support a favoured organization. Consumers in Germany can choose from a number of lifestyle tariffs, and Scandinavians can have tariffs linked to either the forward or spot price of the wholesale market.

Despite frequent news of underwhelming customer service from utility companies, the need to keep customers has led to an increase in investment in this area of their operations. However, the industry's intentions have admittedly been impaired by the (hopefully transitory) problems arising from an unsatisfactory switching process. On the other hand though, online meter reading, compensation for missed meter reads and improved bill accuracy have all made life that little bit better. We can also look forward to the spread of automatic meter reading, which is already being introduced in some European and American regions.

Naturally, none of this would have been impossible in a non-competitive market, but the drive to innovate has led to a marked quickening in the improvement of choice and quality of service.
A less recognized benefit of market liberalization comes from the impact it has on European integration. This can be seen in three main ways: firstly, it fosters increased competition. The arrival of powerful new entrants drives down prices and can introduce best practice.

Secondly, a European wide generation market should be able to meet the continent's energy needs more efficiently than several individual national markets. This works best when generation portfolios are planned on a continental scale - building hydroelectric power stations where there is rain and mountains, nuclear power stations where there is space and CCGT where there is gas. This way, each individual country does not have to achieve a wide spread of fuel types.

The third benefit is more dewy-eyed: the energy industry is too important to the continent's economic and social well being to be riven by international rivalry. It is argued that the development of a European wide market, with cross-border trading and ownership, will foster amity.

Whereas the benefits of residential market liberalization are often questioned, the benefits of business market liberalization are more widely accepted. Switching is much more common in the I&C market, which forces down prices. Sales and marketing costs being relatively low, most of the benefits of falling generation and distribution costs are passed onto business users, particularly at the larger end of the spectrum. And, of course, lower unit prices for electricity are beneficial to the competitiveness of UK industry

Less well appreciated, and arguably more controversial, is the reason why residential market freedom is required for business market liberalization to work. In short, a captive residential base would allow suppliers to subsidize their I&C business by passing some of the costs onto their residential base. This is not only bad for residential consumers, it distorts competition for companies that do not have a residential customer base. Using a residential customer base to subsidize industry may well result in lower prices for customers in the commercial segment, but not in a way that encourages the efficiencies mentioned throughout this article.

For this reason, critics should consider the benefits of business market liberalization before they condemn choice in the residential market. However, a case for residential market liberalization can also be made on its own terms. Competition has introduced long-term benefits, namely cost reduction and product innovation, which should outlive the short-term teething pains of the deregulation process.

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