Private Enterprise and Financial Markets > Infrastructure and Financial Markets > Infrastructure > Energy
Retail Competition in Electricity
By Paulina Beato, Carmen Fuente (03/99, IFM-118, En)
Traditionally, the organization of electric sectors was based both on integrated monopolies and a tight regulation that left no room for market forces. This type of organization found its doctrinal foundations on the natural monopoly character of the electric sector. This meant that power generation, transmission and distribution were less costly when carried out by one integrated firm than when performed by several firms. In other words: scale and scope economies supported the organization of the electric sector around franchised and vertically integrated utilities.
In the middle of the eighties, a new consensus emerged, which questioned the natural monopoly character of the electric sector. Increasing returns may favor that only one firm should provide transmission and distribution services; whereas reduced optimum size power generating plants allows for the participation of various firms without a loss of profits derived from scale economies. This holds even in small countries. As for scope economies among the different electric service activities, the new consensus states that, due to technological developments, transaction costs arising from the unbundling of generation, transmission and distribution are minor when compared with the efficiency costs involved in an integrated monopoly. As a consequence, there seems to be no reason to support the vertical integration of generation, transmission and distribution activities.
Electricity markets are being radically transformed throughout the world. Over the last sixteen years most countries have undertaken reform processes leading to the liberalization of generation. Recently, some countries have introduced competition in the retail segments of the industry.
The main features of the paradigm pushing reform in Latin-American countries are five, as follows. First, large customers, generators and distribution companies enjoy free access to transmission and distribution networks. Second, a pool or spot market for power is established and futures markets for power are also at work in some countries. Nevertheless, in most countries large consumers, distribution companies and generators, may undertake transactions directly without using the organized spot or future markets. Third, wholesale power prices and prices paid by large customers are deregulated. Fourth, a franchise distribution company provides electricity to small and medium consumers. Customers are captives of the franchise distribution company and are, therefore, not free to switch providers in cases of poor quality service. Fifth, the lack of retail competition and free choice for small and medium consumers means regulation is needed to protect them.
Although reforms have resulted in a reduction in wholesale prices, the final outcome may be poor customer service for small and medium consumers, and regulations that disregard customer preferences in terms of price/quality ratios. Retail competition that gives all consumers choices as to how to satisfy their power needs, may promote efficiency in supplying small and medium sized customers and reduce the regulatory burden. The challenge is to introduce retail competition without loosing the scale economies that are inherent to a sole distribution network. In order to do so, most proposals for introducing retail competition usually give consumers and independent retailing companies, direct access to wholesale markets, but they usually maintain a legal or de facto distribution monopoly. As do retailers in other sectors, power retailers buy electricity in the wholesale market and package it to meet consumer demands. Their survival and profits depend on their ability to satisfy consumer preferences and will, therefore, foster a lowering of prices and the development of new products to increase efficiency and consumer welfare. In this case, consumers instead of regulators, decide the appropriate combination of price and quality. By introducing choice at the retail stage through retailing companies or direct access by consumers to wholesale markets, market competition would ensure quality and appropriate pricing at the same time that consumers profit from a single distribution network. Regulators only have to establish rules for the retail market and will not need to set quality standards and prices.
The purpose of this paper is to analyze the issues involved when introducing consumer choice into the power sector. The approaches used by several countries to introduce retail competition are used as illustration to reach the following conclusions. First, forces pushing for consumer choice in the power sector are growing and will soon become a social demand that regulators and utilities in many countries should not ignore. Second, the costs and advantages of free choice can be only evaluated through theoretical approaches, by extending the results from other sectors or pilot experiences. This is because choice in the power sector has only recently been introduced and, in most cases, remains experimental. In addition, the benefits of choice schemes should not be measured by the number of consumers that actually change suppliers, but by the actual benefits, in terms of quality and prices, that arise from consumer choice. Third, although the relative merits of schemes for introducing consumer choice should be evaluated case by case, some degree of unbundling between distribution and retailing services is necessary in order to ensure competition at the retail level. Separation may refer to companies selling services (i.e. those that provide wires services may not be the power provider) and pricing (i.e. the pricing of wires should be an independent and transparent portion of consumers payments when wire companies provide wires and other services). Fourth, although a condition for establishing a successful consumer choice system is the existence of a wholesale market, introducing competition in the retail segment would improve the functioning and increase the competitiveness of the wholesale market. By so doing, retail competition may increase the efficiency of the whole system.
The remainder of the paper is organized as follows. Section 2 describes the forces that are pushing consumer choice and retail competition. Section 3 discusses the features of a general model for retail competition. Section 4 discusses different proposals for introducing consumer choice. Section 5 evaluates the retail competition model. Section 6 discusses the challenges of retail companies. The annexes include the framework for retail competition in five countries.
Last updated: 02/26/07
