Electricity retail competition : from survival strategies to oligopolistic behaviors

1. 34th IAEE International Conference Stockholm School of Economics Raphaël HomayounBoroumand & Dominique Finon; CNRS-CIRED, Paris Electricityretailcompetition : fromsurvivalstrategiestooligopolisticbehaviors

2. Research motivation The risks of electricity intermediation: the need for vertical integration (physical hedging) Vertical integration, multimarket competition and strategic behavior : Great Britain versus Norway Conclusion and policy implications Agenda

3. Retail competition was thought to imply the development of asset-light retailers competing on prices which are cost-reflective Research motivation Asset-light retailing has nevereventuated as expected New entrants bankrupted, weretaken over, or integratedvertically Why has thisorganisational model failed to the profit of verticallyintegratedretailers? What are the consequences on retailcompetition’sdynamic in the general setting of multimarketcompetition?

4. 2. The risks of electricity intermediation: the need for vertical integration

5. Electricityretailers are hybridmarketintermediarieswith real time matchingfunction on hourlymarkets and limiteddifferentiationopportunities • Throughfixedpriceretailcontracts, retailers are delegatedrisk managers • Retailers are exposed to structural quantityrisk (stochastic and inelasticdemand, non storability, short-termsupplyrigidity) and itssubsequentpricerisk • Theoretical paradigm : financial contracts are efficient risk management devices and perfect substitutes to physical assets Riskmanagementasthecorefunctionofelectricityintermediation

6. We compare the risk profiles of different portfolios of assets and contractsthrough the Value atRisk /VaR (95%) The needforphysicalhedging Payoff of the differentcontracts/assetsgiven the spot price All contracts are settled on the spot market.

7. 3000 simulations based on price and volume data from the French market Simulation data

8. Hedging portfolios containing one retailcontractthatmaximize the VaR(95%) The objective is to find the portfolio consisting of 1 MWhbaseloadretailcontract and a linearcombination of financialcontracts as well as physicalassetsthatreducesrisk. The factors for the contracts/assets are alsomeasured in MWh.

9. Resultsimplicationsofnumericalsimulations • Financial contracts are imperfect substitutes to physicalhedging (VaRreduced by 80% compared to a pure contractualhedging) • Absence of liquidmarkets for derivativesmakes options not crediblechoices for retailers (Black-Scholeslimits) • Intrinsicincapacity of the asset-light retailing model to manage efficientlyquantity and pricerisks

10. 3.Verticalintegration, multimarketcompetition, andstrategicbehavior

11. Methodology • In an oligopolisticcompetitionwithout vertical integration: expected Bertrand-likepricecompetitionwithretailpricesaligned on wholesaleprices • In the presence of vertically integrated suppliers, we must depart from this theoretical assumption • We analyze pricing strategies, with potential asymmetrical time-lags in the pass-through of wholesale price changes to retail prices, or beyond a misalignment between retail and wholesale prices alongside a wholesale price cycle • We explain these parallel pricing behaviors by the multimarket setting

12. Great BritainversusNorway We compare two quite “successful” retail markets : Great Britain and NorwayGiven the price transparency and low switching cost in both markets, this allows us to isolate the “multimarket competition” dimension as determinant of competition

13. Wholesale costs and retail mark up: Great Britain Electricitywholesalecostandmarkup 2003-2010 • GB : 14 regionalincumbents before liberalization • A multi-market configuration: The completion of the liberalization process on the residential market segment (1999) was followed by a strong market concentration : an oligopoly of 6 national vertically integrated retailers Retail mark-up follows an increasing trend despite the wholesale prices’ net rise alongside the wholesale price cycle

14. The Norwegianmarket • By comparison to the British market : • Fragmented structure of the Norwegian retail market (150 retailers) with municipalities (benchmark) • Absence of multimarket competition. No homogenous positions of respective incumbents in areas outside their home territory. Those who sell electricity outside their area do not have an extended coverage • Strong alignment of wholesale and retail prices with a constant and quite small mark up even during periods of large price variations • Norwegian retailers use the wholesale price as an opportunity cost to their production. They do not seize the opportunity of having higher mark ups during periods of prices fall or very low spot prices

15. Individual pricing strategies along the wholesale price cycle in Great Britain Trends in suppliers’ revenues per MWh and wholesale prices between 2004 and 2008 • Asymetric patterns and time lags • Multimarketcompetitionand mutual forbearance(repeatedinteractions on 15 geographicalmarkets without threat of entries) leads to a lack of competitive pressure which is reflected in the parallelism of pricing behaviors • Onesinglestrategywhich consists in securing short term profits through higher prices than the wholesale market price instead of offering low prices to corner market shares on a longer run. This is amplified when wholesale prices decrease • Tacit collusion/Collective market power

16. Even when conditions of information transparency and absence of switching costs are realized, the misalignment of retail prices on wholesale prices and parallel pricing behavior come from the market structure • Norwegian retail market structure is not in a setting of multimarket competition and not concentrated • It allows a Bertrand-like price competition to develop Conclusion on Great BritainversusNorway

17. 4. Conclusion • As veryspecificintermediaries, electricityretailers are incentivized to integratevertically to avoidbankruptcy (viciouscircle) • Electricityretailers do not behave as asset-light retailers of an homogenousproduct in a competitivemarket • Vertical integration and multimarketcompetition do not allow the development of a Bertrand-likecompetition • Thesepoor performances contrastwith the initial objectives of retailcompetition…and questions on the relevance of retailcompetition for residentialconsumers and its contribution to the global performance of the power industry • Twopotentialremedies : break vertical integration to be close to the conditions of Bertrand-like competition (complex hedging) or develop a liquid market for financial options (Cf Brazil)

18. THANK YOU FOR YOU ATTENTION