Competition in electricity distribution. By Roxana Saplacan Presented by Ugonna Nwaokwu. Overview.
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Competition in electricity distribution
Presented by UgonnaNwaokwu
The traditional view of electricity distribution is that it is a natural monopoly. Few authors have explored the question as to whether electricity distributors truly are natural monopolies or not, while observation of the current industrial practice tends to suggest that a ‘‘market’’ for distribution activities does actually exist.
In 2002, Stephen Littlechild showed that privatisation of the electricity industry in the UK had made the generation and retail supply of electricity competitive based, on access to transmission and distribution systems. However, he questioned ‘‘whether the remaining fraction could be exposed more directly to the competitive market’’.
In this paper we discuss this question for the electricity distribution sector.
In the electricity distribution case, in practice, monopoly and outsourcing seem to coexist and this gives an ambiguous status to the sector.
Therefore we open this section with a theoretical debate over the question of whether competition for the market could improve productive efficiency of public service utilities.
Firstly, we analyze the literature exploring natural monopoly questions in the context of electricity distribution. We then confront the traditional view to the current practice of the industry in the distribution segment and underline the existence of a form of competition (competition for the market) which seems to be developing in this sector.
Finally, we discuss the organisational and policy implications of introducing competition for the market in this segment.
We conclude by arguing that indeed, the traditional approach considering the electricity distribution sector is that of a natural monopoly and that this seems to be appropriate when it comes to provision of the infrastructure (the low voltage wires). It makes no sense to duplicate an electricity distribution network if access to it can be granted for all customers at an economically efficient price.
However, our main argument is that what is essential in understanding industry practice is to distinguish the provision of the infrastructure from the provision of the supplied services associated with it. The services, in this case, are not only the delivery of electricity to connection points, but also operating the infrastructure and maintaining a defined quality of service.
Our proposal is, hence, to consider the separation between (a) infrastructure provision in distribution and (b) associated services. We draw some lessons from other network industries, which would imply the possibility of putting distribution operation activities out to tender, either partially or wholly.
It is generally assumed that competition is impossible in the electricity distribution business. This has been explained by the presence of local electricity networks, which cannot be duplicated at a reasonable cost (Newbery, 1999). Hence, these networks have natural monopoly characteristics which justify, indeed necessitate, public regulation of the sector.
However, in the 1960s, the failures of regulation raised a debate on the alternatives to traditional modes of regulation, initiated by Demsetz (1968). He argued that, ‘‘the theory of natural monopoly is deficient for it fails to reveal the logical steps that carry it from scale economies in production to monopoly price in the market place’’.
Thus, even if scale economies impose a single supplier ex-post, competition is possible through auctioning the right to serve.2 This way, competition would lead to a lower price than the natural monopoly price, due to the initial selection of the most efficient candidate.
From this paper, I figured out that the network part of the business, the ‘‘distribution’’, kept its regulated monopoly status, while the ‘‘supply’’ part has been opened to competition.
In the economic literature competition is the most appropriate ‘‘tool’’ to improve efficiency. However, competition is impossible when the reproduction of the infrastructure is uneconomic or when the cost of the good or service is the lowest when supplied by a single firm. The latter is the case of ‘natural monopoly’. It is considered to apply in the case of electricity distribution as it is widely believed that one company can distribute energy at a lower cost than any two companies with two parallel infrastructures.
Few authors have empirically explored the question as to whether the underlying cost structure of electricity distributors really indicates a natural monopoly:
(Kinnunen, 2003; Viljainen, 2005; Ajodhia, 2006) assume that distributors are natural monopolies. Indeed, it is always less expensive to connect a new customer to an existing network rather than building a parallel network for this purpose.
In 1998 Salvanes and Tjotta studied the Norwegian electricity distribution sector and found that it is characterised as a natural monopoly. Their subadditivity test shows that the mean output is more efficiently produced by a single firm than by two firms, considering all feasible share of production for both firms.
In 1999, Gunn and Sharp questioned the natural monopoly characteristics of the distribution considering that ‘‘while much has been written on the electricity industry in general, little attention has been focused on electricity distribution. This is probably due to widespread acceptance of the belief that it is a natural monopoly’’.
In 1987 the Government of New Zealand removed the exclusive territorial franchises of electricity supply companies in order to allow them to compete with each other for retail energy services. As a consequence, each distributor obtained open access rights to construct new lines in any of the other companies’ previous franchise areas. Thus, ‘‘the companies responsible for electricity distribution and retailing in New Zealand are in fact competing with each other, not just for retail services i.e. energy sale, which was intended, but for distribution services as well i.e. network connection’’. As this type of competition seems contrary to the natural monopoly hypothesis in electricity distribution.
According to Gunn and Sharp (1999) ,New Zealand’s regulatory regime is such that ‘‘electricity distribution has taken on the two key characteristics of a contestable market: no barriers to entry (particularly in the form of sunk costs) and no price response by the incumbent to entry by a competitor’’. The authors concluded that, New Zealand’s electricity distributors may well be sustainable natural monopolies even if this regime introduces elements of contestability which, in theory, might allow potentially inefficient competitive behaviour.
The first limitation is related to the unbundling of the distribution activity from the supply activity as imposed by the European Directive. The aim was to stimulate competition in a sector which had historically been vertically integrated. Thus, these Directives led to a reorganisation of the distribution business and to consequential changes in the cost structure of distribution companies.
The second limitation is related to the cost structure of a distribution company. The evaluation of their costs should take into account fixed costs as well as variable costs, i.e. capital and operating costs.
The third limitation is related to the current transformations of organisational forms of distribution companies
Hence we propose a view that clearly distinguishes between (a) the owner of the network and (b) the operator of the network. In what follows we provide practical examples supporting this argument.
The current allocation of functions of the electricity distribution sector makes the studies discussed above (Salvanes and Tjotta, 1998; Gunn and Sharp, 1999) difficult to apply. The reason is that the authors have studied distribution using a single cost function with natural monopoly characteristics while current practice in the industry shows that part of these ‘‘monopolistic’’ activities are less expensive when performed outside the supposed monopoly. For example in France, part of distribution activities are either ‘‘shared’’ between EDF distribution centres or fully externalised to third companies. In the United Kingdom the situation is similar: distribution activities have been contracted out to companies other than the owner of the network (EDF Energy won a bid for ensuring the maintenance and reliability of London Underground network).
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