Electricity Retailing: A Second Generation Issue of Power Sector Reforms

The main goal of first generation infrastructure reforms was to introduce competition in the markets where possible and consequently, first generation reformers made great efforts to look for segments in which competition in the market could work. Thus, vertical monopolies were unbundled, wholesale competition was introduced, and infrastructure sectors have been radically transformed throughout the world. Following the path of first generation reforms, after Chile's and the UK's pathbreaking experiences, many other countries have undertaken reform processes leading to the liberalization of power generation. The results have been wholesale power markets which permitted the operation of non-utility firms and self-generators able to produce cheaper electricity, and established open-access to transmission networks to all generators, large consumers and distribution companies. In most countries, open access to the transmission network was carried out by the legal or financial separation of integrated utilities into three difference companies: generation, transmission, and distribution, and by allowing open access to transmission networks on a common carrier basis. However, on the demand side, only distribution companies and large industrial consumers benefited from that first stage of electricity markets' journey away from monopoly and competition. Medium and small consumers remain prisoners of their local utilities. Small and medium consumers have not obtained the right to use markets on an equal basis with large consumers, distribution companies and generators.

Implementation of retail competition is underway in a host of countries. This has become a major challenge of second-generation reforms. Once full retail choice is at work, the liberalization of power markets will be completed. Commercial and domestic customers will become "regular" contestable customers, able to choose the electricity supplier best able to provide the bundle of products and services that best suits each customer's needs. The challenge lies in introducing retail competition without losing the scale economies inherent to a unique distribution network. To that end most proposals for introducing retail competition usually give consumers and independent retail stage, through retail companies direct access to wholesale markets, but distribution remains a legal or de facto monopoly. Power retailers like retailers in other sectors, buy electricity in the wholesale market and package it adapting it to consumer demands. Their survival and profits depend on their ability to meet customer preferences, increase efficiency and consumer welfare. By introducing choice at the retail stage, through retail companies or direct consumer access to wholesale markets, market competition ensures quality and appropriate pricing while at the same time making it possible for consumers to profit from a single distribution network. Regulators will no longer have to set quality and prices, only retailing market rules.

Although, so far, actual customer choice in power sectors is limited, social pressure in favor of less regulation and more consumer freedom are common in a sizable portion of the world. For instance, most states in the U.S. and European Union nations are engaged in or have carried out reforms that will allow consumers to choose their power supplier. New Zealand has recently introduced new regulations to extend the benefits of competition to all consumers. In October 1997, Colombia modified the structure of distribution tariffs, separating power delivery services from transmission services, with the purpose of promoting retail competition. The same forces that transformed the banking, telecommunications, and airlines industries in the recent past are propelling this transformation process. However, the change in the power sector is now expected to come quickly, hopefully, within a few years rather than over decades, and will be pushed by specific forces coming from within the sector itself.

One such force, regulatory failure, is the general claim that regulation has failed to deliver low electricity prices. Large differences in average prices are observed across countries and across regions or states of the same country. High average prices, an indicator of potentially large welfare gains as a result of competition, have a positive influence on the propensity of country and state legislatures to introduce initiatives hat favor competition. A second force ahs to do with transparency; consumers have become aware of the implication of cross-subsidy practices. For decades, electric power has been delivered to consumers by a patchwork of utility monopolies able to price-discriminate against residential and commercial consumers in order to maintain the loyalty of large industrial customers. Therefore informed small- and medium- sized customers are the regulator's best allies when it comes to supporting efforts to introduce retail competition, whereas large customers usually side with the incumbent utilities in opposing any change that might endanger their vested interest. Another important force is the reduction of metering, communication and computational costs. In retail competition schemes, metering by time of use is no longer merely a way of promoting efficient usage, it becomes a commercial necessity and a unique source of information. Each customer needs to be metered according to his settlement period, on an hour of half-hour basis. Since power prices change 24 or 48 times per day, it is necessary to know how much the customers of each competing retailer used in each settlement period, in order to be able to bill customers and settle accounts correctly.

Schemes for introducing retail competition have the following components: a retail arrangement, a market mechanism, and a set of prices for network use. The organization and relationships between consumers, retail companies and distribution companies define the retail arrangement. One of the main issues to be solved is the degree of separation between distribution companies (companies owning the transmission lines) and the retail companies (companies selling the power services). In some proposals, distribution companies are not allowed to sell power, while in other a distribution company may sell both power and transmission services. The market mechanism refers to procedure and rules to govern the ability of generators to buy and sell power. For example, in some schemes, trading has to take place through organized power markets, while in others consumers and generators are free to enter into contract. In most schemes, access to bulk markets by medium and small consumers is restricted. Some restrictions are justified to ensure participant commitments but others may only restrict competition. Many options have been discussed regarding pricing. The options fall within a wide range. One extreme is to set prices jointly for both power and transmission at different points of the network. Most options separate generation and transmission prices and let markets fix power prices, while regulators usually control transmission prices.

The advantages of retail competition schemes can be characterized as transforming the stodgy monopoly utility culture into a normal competitive business culture. Hence, the benefits of implementing retail competition in power sectors are similar to those attained when introducing competition in any industrial sector. First, retail competition reduces the regulatory burden because full retail choice schemes are expected to progressively replace regulators in many fields. The pace and scope of the replacement process will depend on, among other factors, the political will of the regulatory authorities and on the technological and institutional features of the sector. Second, these schemes favor efficient pricing. Retailing allows price arbitrage when costs are not properly reflected in prices, therefore favoring efficient pricing. Competition among retailer will advantageously replace tariff regulation by delivering cost-adjusted prices with no cross-subsidies or excessive margins. Third, economic agents face the appropriate incentives to develop new technologies. In order to increase market shares and profits, retailers will attempt to differentiate their services and offer a wide range of products and services.

Nevertheless, the most important benefit of a retail competition model is its ability for enhancing consumer attention and increasing customer's freedom of moving away from expensive low quality energy providers. There is no doubt that consumers' ability to choose and change retailers constitutes the most efficient regulatory mechanism. When the industry reacts to the new scenario in which previously franchised subscribers are placed at the center of the stage by way of becoming sophisticated clients of a diversified and dynamic retail market. New entrants and information technology are expected to reshape and update the entire retailing business.

-Paulina Beato, Principal Economist, Infrastructure and Financial Markets Division
-Carmen Fuente, Economist

Last updated: 01/16/07