Separation of Retail and Distribution in Electricity Supply

Energy Forum Papers

EXECUTIVE SUMMARY

Requiring distribution and retailing of electricity to be undertaken by legally separated firms is unnecessary.  Regulated line charges and access conditions ensures full competition in supply.  Directing businesses to place distribution and retailing within separate companies adds to operational costs and prices, and overrides the wishes of those customers who prefer to have one supplier for both energy and distribution.

It is essential to have accounting separation of retail and distribution business in the electricity supply industry.  Requiring legal separation of these two parts of the electricity supply industry is unnecessary.

Although there is a plausible case for enhancing competition by separating retail and distribution into separate businesses, this has two major deficiencies:

• additional costs of overheads and bill management would be incurred and passed on the customer;  counterbalancing benefits are not evident;  and
• those customers who wish to deal with only one supplier will be inconvenienced;  this is particularly the case with smaller customers.

The availability of rival suppliers, who have low barriers to entry, puts considerable pressure on incumbent distributor/retailers to ensure they remain competitive and it would be wasteful to impose needless costs.

Competitive outcomes in the UK and Victoria have proven that vigorous retail competition can take place without legal separation between retail and distribution.  In both these jurisdictions, accounting separation between the two arms of the distributor/retailer and regulated line charges that are available to all retailers has ensured strong competition and customer orientation.

The high degree of "churning" in both the UK and Victoria -- where over 40 per cent of contestable customers take their retail supply from a non-host retailer -- demonstrates the effectiveness of the present accounting separation approach.  The benefits of lower prices have extended to customers generally, including those that have remained with their host retailer.  Retail prices to Victorian contestable customers in the 750 kWh/year class have shown estimated average reductions of at least 9 per cent.

Drawing from the experiences in New Zealand where all customers are contestable, a lesser degree of switching is expected with smaller customers.  However this largely reflects the relatively high metering costs such customers would need to incur and their preference for having a common distributor and retailer.

INTRODUCTION

A major approach in both the Victorian and NSW electricity market restructuring has been the structural separation of generation from transmission and system control, and from distribution and retailing.

Requiring the separation of these elements of the electricity supply industry was prompted by a number of factors.  Important among these was the wish to prevent businesses using their monopoly positions in ways that would impede the achievement of efficiencies from competition.  With generation, barriers to entry could exist as a result of high fixed costs and low variable costs.  An integrated monopoly has considerable incentive to engage in cross-subsidisation which penalises rival suppliers.

In neither Victoria nor NSW are all elements of the structural separation required to be permanent and, in fact, the parent company of one of the Victorian distributors is part owner of a major generator, whilst two of the NSW distributors have taken equity in new generation facilities.

As well as these state based reforms, the initial separation of distribution and generation was an essential goal of national reforms.  South Australia's early reluctance to break the nexus between its generation and distribution led to an Industry Commission review and that state's agreement to legislate for a full legal separation.

The initial requirement to split generation from retail was a major feature of the UK reforms on which those in Australia have been based.  That country too has permitted subsequent investment by distributors in generation.  Indeed, UK retailers are now responsible for a significant portion of energy generation, while UK generators have won a high share of the contestable retail market from retailer/distributors.

In California, where the provision of electricity was always largely in private hands, the Public Utilities Commission (CPUC) did not rule that separation must take place.  The CPUC did require an independent system operator in control of transmission and an independent market control system.  It also put in place incentives for the three major integrated suppliers to structurally separate distribution/retailing from generation.  All three are following this course.

There are very sound reasons why previously integrated structures that have developed under government monopolies or government control should start their new existence with separate production, transmission and distribution facilities.  Such separation allows a genuine market to develop unencumbered by any incentive to favour a related firm.  It also does not rule out future reintegration should there becompelling economies to be gained from this.

The reasons for requiring de-integration are not present in the case of retail/distribution and few jurisdictions have required it.  In retailing, fixed costs and therefore barriers to entry are low where the retailer is assured of fair access to the wires and where there is an availability of competitive power supplies.  Low entry barriers mean the distributor cannot recoup the costs of squeezing out a rival retailer by subsequently raising its own prices since another rival would quickly emerge.

RETAIL AND DISTRIBUTION SEPARATION

CONSIDERATIONS IN ELECTRICITY SUPPLY

It is inputs into a shared system that are most obviously open to discriminatory treatment.  Once power is in the system it follows immutable laws of physics rather than being subject to human discretion.  A system controller could operate in a non-neutral fashion in ways that benefit individual participants, e.g. setting power interruption protocols that favoured certain regions;  or offloading rival generators where the system is producing surplus power.  A transmission business too could favour related businesses in its investment and planning decisions.  For these sorts of reasons it is essential that system control be totally detached from other parts of the supply industry and highly desirable for transmission also to be independent.

It is more difficult for a distribution wire owner to put in place strategies that favour its related parties where agreement to open access is clearly understood and regulated.  The incentive against granting any favourable treatment to a related retailer is further reinforced by the charging requirements for the wires.  Because the wires are treated as a natural monopoly, rates are specified by the regulator.  In addition there will eventually be full opportunity for by-pass as a discouragement to excessive charging and economic inefficiencies.

The main advantages a retailer/distributor may have within its home territory are:

• the knowledge it has about the load profile of different customers;
• an ability to bundle energy with other services so that economies are made and keener prices can be set;
• superior information it might have about the true costs of particular parts of the network, which may allow it to cross subsidise retail services to customers whose wire charges are set too low.

In practice, the following discussion shows these advantages to be slight.

Load profile advantages

There is an advantage in having automatic access to customers' load profiles and regulators will require confidentiality between the two arms of the business;  ⁽¹⁾ any advantage the distributor's retail arm might have is further muted by the ability of the customer to seek a better deal by providing this information to other retailers.  However, the distributor is in a preferred position for those customers who are less inclined to search out what are likely to be only modest savings.  This is reinforced to the extent that the host distributor would charge other parties or the customer for providing historical data.

Bundling of services

Economies are available to the distributor which has to have customer service facilities in its own area.  That said, it would be economic vandalism if costs were purposely increased by disallowing combined uses of labour unless there were strong advantages stemming from a resulting increase in competition.

Cross-subsidies where costs are set too low

It is most unlikely that a regulator will know as much about the costs a firm incurs as the business itself knows.  There will be areas of a region that cost less to service than other areas and the superior information that the retailer/distributor has could lead it to pitch particularly competitive prices in that area.  Accounting separation addresses this, albeit not perfectly.

There would be concern if a transmission company also owned part of the distribution network because this may give rise to actions that favour the part that is under common ownership.

ELECTRICITY INDUSTRY REVIEWS

The above considerations have been tested in a number of studies.

The National Electricity Code is largely silent on retail arrangements -- in fact Chapter 5 states that retail trading is left to the jurisdictional regulator.  All network service providers must agree to an access arrangement under the provisions of the ACCC.  The Code limits its statements to ones that describe how pricing should be arranged.

Similarly, in neither of the NSW and Victorian legal instruments is there any provision for requiring structural separation of distribution from retailing.  However, in July 1996, the NSW Electricity Reform Taskforce issued a paper ⁽²⁾ requiring, "a licence holder to maintain separation of its licensed 'monopoly service' business from other business affairs." Separation was not envisaged to be necessary in the case of a retail licence but for a distributor, (which is automatically obliged also to have a retail licence), the separation was to begin immediately and to cover:

• "keeping separate accounting and business records;  and
• the allocation and costing of jointly used resources on an arms length basis."

The Industry Commission (IC) in its review of South Australia ⁽³⁾ pursued a line of analysis sympathetic to the NSW Taskforce paper's approach, arguing that:

"a potential problem with integrating distribution and retail is that it creates some incentives to operate in an anti-competitive manner.  For instance, there would be the scope and incentive to use the network side of the business to protect its retail business."

The IC went on to say:

"Through the course of the Commission's review, various views were put to the Commission opposing the separation of distribution and retail, including:

• the ability of the retail staff to offer 'effective' innovative solutions to demand side management would be impaired;
• both businesses essentially deal with the same customers;
• the asset backing of the network business, and its regulated cash flow provides diversification against the riskier, low asset retail business;
• the combined organisation would be better able to develop pricing packages to address capacity constraints and smooth load;
• the small margins in retail, the low volume of sales to individual households and small business, and the cost of enticing customers to switch retailers;  and
• the uncertainty about future pool prices in the national market."

Added to these issues is the fact that where customers wish, out of inertia, to remain with their incumbent retailer, it is better that their retailer has a significant stake as the wires business with all the obligations and asset backing this entails.  Moreover, should a non-wire owning retailer default, an incumbent distributor/marketer is best placed to be required to operate as the fall-back supplier, (a retailer of last resort).

The IC concluded:

"The evidence provided to the Commission suggested that there are likely to be some practical difficulties in separating distribution and retail, at least in the early stages of the national electricity market." (Chapter 6 p. 108).

Hence, while showing a preference for disaggregating retail and distribution, the IC was not persuaded that their would be sufficient economies to recommend such a course.  It considered that, "Retention of retail with network activities will therefore require a significant regulatory effort on the part of the proposed regulator.  It will be important that regulation of distribution access be rigorous and that ring-fencing of retail and distribution have a high degree of transparency."

Queensland is the only other Australian jurisdiction that has addressed these matters.  Following an inquiry, ⁽⁴⁾ the Queensland Government has announced that it will retain the existing distributors but hive off retailing into three separate businesses.

There is, however, no apparent call for such separation in either the US or UK.  Indeed, neither the Californian nor the Federal US regulations even discuss a need to disaggregate retail activities from distribution.

THE GAS CODE AND ISSUES RAISED BY THE NSW INDEPENDENT PRICING AND REGULATORY TRIBUNAL (IPART)

IPART has drawn attention to the different approach to separation in the gas and electricity codes.  It intends to require the structural separation of retail from distribution in electricity. ⁽⁵⁾

The draft National Third Party Access Code for gas specifies in s 4(2) that the Regulator may require the business to have a separate staff and directors for the Service Provider independent of those controlling other parts of the business.  There is a saving clause 4(2)(b) which requires that the ring fencing should not impose unreasonable compliance costs.

Irrespective of the merits of structural separation for gas, there are significant differences between gas and electricity.  The means of transporting gas are more flexible than those for electricity.  The nature of the product and its storability mark gas as being different from the instantaneous nature of electricity supply.  In addition, the constraints on gas pipeline capacity on peak days and during needle peaks are not commonly found in electricity, the lines for which have ample capacity.  No Australian electricity generator has, as a result of this, shown any interest in taking out insurance to ensure its load will be scheduled.

In the case of gas there is much support for structural separation.  Following deregulation in the US, virtually all major pipelines transformed themselves solely to transport providers.  Energy Probe has made representations to reviews of gas and electricity in Manitoba and Ontario. ⁽⁶⁾

THE CASE AGAINST REQUIRING SEPARATION

The reasons for requiring a split of retail and distribution are:

• to simplify the regulator's task in managing the distribution side of the business;
• to guard against anti-competitive activity.

Simplification of the regulator's management of distribution

The key issues in requiring firms to take actions that they would not willingly take of their own volition is whether there is a net gain to the community.  The net gain would have to take into consideration improvements to market operations, any loss of confidence based on reversing previous expectations of regulatory approach and costs that would be incurred to the regulated firms (and therefore borne either by their shareholders or customers) and to the community in terms of regulatory resources.

In the case of the electricity industry, regulatory intervention would be undertaken from a pro-competition perspective, but intervention it would be.  The degree to which competitive rivalry gains would be made to offset any costs becomes a pragmatic question.  Although lower costs to the regulator is an important consideration, we need to avoid incurring additional costs to the industry that more than offset these.

The costs to the distributor/retailer are likely to comprise additional personnel for separate boards, call centres, maintenance staff, reporting requirements and so on.  AGL has estimated these separation requirements for its gas supply business in NSW as adding three percent to its costs.  It is likely that such cost increases will be passed on to customers.

Combating anti-competitive behaviour

Anti competitive behaviour can refer to either predatory pricing or to benefits offered to a sister retail company that are not available to other retail businesses.

There is a negligible possibility of predatory pricing in the contemporary Australian electricity markets that have a number of different suppliers and low entry barriers.  A firm hoping to deter a rival by "buying" customers would see any subsequent attempts to recoup its costs frustrated by other rivals undercutting it on any excess price it subsequently attempted to charge.

The question remains whether, at least in the case of electricity, a host retailer is able to benefit from cost shifting and whether it is cost-effective to prevent this.  There is very modest scope for cost shifting between retail and wholesale.  We estimate these at a maximum of 2 per cent of the distribution revenue -- and well managed reporting procedures could significantly reduce this.

Furthermore, separation into different retail and distribution companies will not be effective in preventing secret and favourable discounts to host retailers with a common shareholding.  If a gain is available, the management of the separate entities will find ways to exploit it.

Access rules provide the best means of preventing this.  The customer must be made aware that any tariff offered by the incumbent distributor is also available to other retailers.  Providing this course is followed, the incumbent obtains no advantage through discounting.

Appraisal of competitive outcomes

The benefits of requiring a separation for electricity, while conceptually present, are not apparent in practice.  If the incumbent distributor/retailer were to enjoy strong market advantages, we would expect to see little change in market positions where customers are made contestable.  In fact, the experience in Victoria and the UK has been that some 40 per cent of customers have switched retailer once given the opportunity.

Moreover, contestability without structural separation, even where customers have remained with their host retailer, has delivered gains to customers across the board.  Retail prices to Victorian contestable customers in the 750 kWh/year class have shown average reductions variously estimated to be between 9 and 15 per cent.  These reductions have been achieved by customers who have stayed with their host retailer as well as those that have shifted.

The switching that has taken place has been much higher than had been anticipated.  There are a several reasons why little change in retailer was to be expected.  First, the margins for retailers are relatively slender -- most estimates in Victoria prior to privatisation estimated that over 90 per cent of the distribution businesses' profits would be derived from their wires business.  Secondly, all retailers derive their basic power from a common source and the scope to offer low prices to attract business was not considered to be great.  Thirdly, there was expected to be a considerable amount of inertia and uncertainty, especially at the early stages of the contestable market.

It may be that an even higher degree of retail churning would have occurred had the nexus between wires and retailing been forcibly severed.  But there have been few voices claiming this in Australia.

One country in which a relatively lowproportion of power, 7.5 per cent, is delivered over the lines of non-host retailers is New Zealand.  In that country all customers are contestable and there is no structural separation, beyond accounting separation as in Victoria.  The relatively low inroads made by non-host retailers in New Zealand may be partly due to the fact that over 60 firms share the retail business.  Accordingly, the retailer/distributors are small (or were prior to a very recent spate of takeovers).  It is also likely to be partly due to the comparatively high cost of sophisticated metering smaller users would incur and the relatively low incentives rivals have to seek out new business in that half of the total market comprising smaller users.

Cheaper metering and increased market aggression in New Zealand may bring a higher share to non-host retailers, but most smaller users are likely to see merit in remaining with their host, especially as this gives them a single contact point in the event of difficulties.

Barriers to entry in retailing are low and competition, even at the margin, is likely to narrow any price differentials.  Though the cost savings from a combined retail and distribution business confer an advantage on the incumbent, it is surely not appropriate to force change by requiring costs to be incurred and inconveniencing the customer when there are negligible gains to be achieved.

CONCLUDING COMMENTS

The results of the contestability process to date are prima facie evidence of a lack of market power on the part of the incumbent wires business to prevent rivals from competing on a level basis.  The fact that forced separation would result in costs being incurred indicates that such a measure is not justified.

Costs aside, the most powerful argument in favour of not requiring structural separation is that mandatory separation might disadvantage those customers who wish to be inert in the electricity market.  Some customers may wish simply to retain their existing supplier on the basis that it is not worth the effort of searching out a new retailer but want continued supply by a retailer with sufficient assets to guarantee a continuation of their existing service.  A retail-only firm may not be in such a secure position.

Providing service has been satisfactory, as in all businesses, there is likely to be some advantage in being the existing retailer.  This is not, of course, sufficient reason to prevent incumbency.  Even a highly protected incumbent is constrained in its ability to exploit any consumer preference it might hold.  And the electricity retailers have little such protection.  Larger customers have already demonstrated this and even for smaller customers the lower costs of smart meters, and the operations of rival retailers and energy brokers making use of load profiling places severe restrictions on the incumbent's ability to charge a premium price.

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ENDNOTES

1.  In Victoria, the Regulator's Guideline No. 1 says:  "A licensee must not (without a customer's explicit informed consent) make available to its retail arm customer information that would give the retail arm an advantage vis a vis another retailer." (para 7.2.2)

2.  "The NSW Electricity Supply Industry:  Information Paper on the Transition to Full Retail Competition", NSW Electricity Taskforce, July 1996.

3.  "The Electricity Industry in South Australia", Industry Commission, April 1996.

4.  "Reform of the Queensland Electricity Supply Industry", Queensland Electricity Structure Task Force, December 1996.

5.  In "NSW Energy Access:  A Guide", The Independent Pricing and Regulatory Tribunal of NSW (Sept. 1996), said, "An effective network access regime and accounting and behavioural separation will together ensure that the regulated monopoly network business does not shield the retail supply business from competition." (p. 5)

6.  Energy Probe's Prefiled Evidence in Manitoba Public Utilities Board June 1996 Inquiry into the Future Role of Centra Gas Manitoba argued:

Separating Gas Merchant from Distribution Functions in Manitoba

Incomplete divestiture of the merchant business would be a costly second-best relative to complete separation.  Problems created by adopting the second best include the question of how to manage and regulate affiliate transactions, who should bear the cost of regulating affiliate transactions, how to impute a value for the use of the utility's name, what to do about the utility's special access to information about customers such as load patterns and credit history, and how to ensure comparability of service to affiliates and competitors.... In the event of incomplete divestiture, affiliated companies and utility parents will have powerful profit-based incentives to skew the outcome in their own interest..

Cleanly separating the merchant function from the distributor through a change in ownership eliminates these difficult problems.  Affiliate transactions would not be an issue because the divergent interests of different owners would eliminate the problem of cross-subsidies.  Without the risk of cross-subsidies, there would be no need for regulatory oversight over the merchant.  The value of utility's name and reputation would be recognized in the sale price.  Similarly, information obtained by the utility merchant would be recognized in the sale price but after the sale, the former utility merchant would have to obtain market information by the same means available to any other vendor.

In its January 1996 submission to the review of Ontario's Electricity System, Energy Probe called for disaggregation, including structural separation of distribution and retailing.  But the submission did not offer a clear path to effect this and suggested a transition period would be necessary.