Do we believe in retail competition?
June 25th, 2007 by Clara Poletti, Universita Bocconi di MilanoFew days are left before the complete opening of the retail electricity markets: in the 1st of July households will be able to take competitive supply of electricity. What should they expect from the market liberalisation? The answer will depend very much on whether policymakers trust retail competition as an efficient mean to deliver cheap and reliable electricity to final customers, especially households and small commercials.
Empirical evidence shows that, since the liberalization process started, most European retail markets for electricity have been taken “into custody” by means of regulated tariffs. Worst, regulated tariffs often did not reflect correctly current cost levels or cost structures, generating relevant cross subsidies. These regulatory distortions need a resolution if the market is going to have any chance of functioning properly.
ERGEG, the European regulators’ group for electricity and gas, has recently published a Review on end-user price regulation in European Countries that draws a noteworthy picture of the retail energy markets in Europe.
In the electricity sector in 2006, 17 out of 28 countries surveyed had some form of retail price regulation for eligible customers. Moreover, when regulated tariffs were available only a very small percentage of customers had switched to the competitive market: in most market segments more than 80% remained at regulated tariffs and in many segments this percentage was close to 100%. Finally, only in one country, Hungary, the suppliers offering the electricity for regulated tariffs were selected on the basis of an open tender.
It is worth noticing that a low switching rate is not necessarily a signal of a badly functioning market or a proof of inefficient tariff regulation. For example, one could argue that potential competition from new entrants can discipline firms already operating in the market and, if the reference price set by the regulator is sufficiently close to the efficient costs of supply, the customer would not benefit from switching.
However, in practice, in many European countries the low switching rate has been determined by distorted tariff regulation, especially for small commercial customers. Regulation has often raised barriers to entry, hindering competition in the retail market. The ERGEG’s report gives two interesting examples of end-users’ tariff regulation compared to market prices: Spain and France, two countries where all eligible consumers can opt for regulated prices set by government. Over the last two years regulated tariffs have been significantly lower than market values (i.e., wholesale price plus transmission); as a result, in 2006, in Spain 54% of small business customers were still supplied by their local default supplier at regulated tariffs and in France this percentage was 89%. Many other examples could be made.
Most European countries see end-user price regulation as the main tool for customer protection. The question that remains to be answered is: what kind of protections are regulators seeking by regulating (only) end users tariffs in a sector were the wholesale market is open to competition? In order to answer this question it might be helpful to have a look at costs. Let’s take as an example the estimated cost of supplying a typical Italian domestic customer with 3 kW of capacity and 3000 kWh of yearly consumption. This estimate is based on the reference tariff, called D1, published by the regulator for the second quarter 2007. The total annual costs is about € 400 (before tax) and it is largely explained by the cost of energy (€ 270), that is the cost a supplier has to support in order to buy in the wholesale market the electricity necessary to satisfy the customer’s demand. Instead, costs directly related to the retail activity appears to be very small: total commercial costs, including the billing of transmission, are estimated to be around € 14 a year per customer. The remaining € 145 is the cost of transmission and metering.
It is therefore clear that the potential reduction in direct costs that a more efficient retail could bring about is very limited. The real challenge is to reduce wholesale prices and, as a consequence, the mentioned “cost of energy”: this is the kind of protection regulators should have in mind. Regulated tariffs, if they are not cost reflective, might be more a glitch than a protection for customers.
Clara Poletti, Università Bocconi di Milano
June 27th, 2007 at 10:35 am
I don’t think that squieezing the retail costs is the only objective of this liberalization. i am personally enthusiastic about the idea of switching to a provider of renewable-only energy. i think this opes for some custoners the chance to put their money where their mouth is, even if it costs more. in perspective, since all retailers must indicate the mix of energy sources they provide, there could be differential taxation favouring renewable resources and thus it could foster further the EU goals for climate change
July 25th, 2007 at 1:06 pm
I fully agree with the author that a mix of retail competition and regulatory intervention in the retail market is quite undesirable as in the long run it may not protect consumer interests at all. At the same time, market power in retail markets is a real problem that is not only due to government intervention. In addition to the obvious cases where incumbents have a dominant market share, we observe that consumers may be very ‘sticky’, giving even retailers with a modest market share influence over prices. Consumers do not appear to be willing to spend the time and effort – however low – of switching electricity provider until something bad happens to them, such as a power outage (for which the retail provider actually is not responsible) or problems with billing. In the Netherlands, for instance, where there is no government intervention in retail markets, only 17% of consumers have switched since the market was fully opened three years ago, despite significant price differences between providers. Now that we have full retail competition in the EU, we need to find solutions to this issue, as well as a way of dealing with large incumbents, if retail competition is to contribute to a more efficient power supply.