Tuesday, October 20, 2009

The green light for vertical integration in the energy market

At what stage in the development of a competitive industry does vertical integration become a good thing?

This question arises as the NSW Government enters the process of selling off their electricity generators, and the energy retailers are expected to be the buyers.

Today the Australian had an article discussing the sale of about $6 billion worth of NSW state-owned electricity generation assets. Whilst the sale process will be open to all investors, the article suggests that interest will come from major electricity retailers including Origin Energy, Integral Energy, TRUenergy and ERM. Yet, governments and regulators across Australia have put in so much work to remove vertical integration from the energy market. So why would we be allowing this shift back to vertical integration? Because it can reduce electricity prices.

Vertical integration often leads to market inefficiencies (particularly in monopoly, monopsony, oligopoly or oligopsony markets). This has been highlighted in the recent discussion regarding the de-vertical integration of Telstra (vertical disintegration is a different thing altogether). Vertical integration in market structures where a few participants have price discrimination power enables the vertically integrated company to price gouge in the monopoly/oligopoly components of the business. The company can then cross-subsidise those components of the business that are open to competition - effectively opening up a cartel pricing scheme. So why then, if vertical integration these markets is a bad thing, would the government be happy to allow for re-vertical integration of the energy market?

To my mind, there are three reasons why this re-integration is a positive (or at least an acceptable) outcome:

1. The perfect hedge – currently, retailers and generators minimise their risk through over the counter transactions. This enables retailers to purchase the majority of their load at a pre-arranged price, rather than facing the volatile NEM price. It also enables generators to guarantee demand even in low-consumption periods. Whilst this is a good system, the contracts are agreed to ahead of time and any variance between the agreed contract consumption and the actual consumption has to be bought on the NEM at an unknown price.

When retailers and generators merge, they are able to better hedge their demand and price risks. So long as the price the generator offers the NEM is low enough so that the generator’s offer is accepted and dispatched, the retailer and the generator can have a perfect hedge.

2. The market structure of the NEM – the NEM is not a typical Oligopoly or Oligopsony, rather, it is both. There are a few large generators and there are a few large retailers. Having both the buyers and sellers in a market with considerable power in some ways removes any price discrimination power that could occur in a standard oligopoly/oligopsony.

3. The regulation of the NEM – even with vertical integration, the dispatch system used in the NEM ensures that the energy needs of the market are met by those generators willing provide the energy at the lowest possible price.

There is still considerable room for gaming on the margins of the market, but not considerably more than is currently going on.

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