Vertical integration business model in electricity markets – can it survive?

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Vertical integration by a business combines different functional elements of a supply chain within a market. Generally, the benefits of vertical integration reflect the perceived and expected efficiency gained by:

  • Addressing coordination challenges between functional elements
  • Effectively combining assets/services to the benefit of consumers
  • Reducing transaction costs associated with coordinating functional elements
  • Reducing risks and volatility of the exchanges (both financial and physical) between functional levels.

For Australian energy markets, vertical integration of functional elements of retailing, generation, and fuel supply occur to resolve coordination challenges, maximise use of assets, reduce transaction costs, and reduce risks and volatility in market pricing of transactions between functional elements. Figure 1 provides examples of the types of matters expected to be resolved by vertical integration of functional elements within the energy supply chain.

Figure 1 Vertical Integration

Figure 1: Types of commercial matters resolved by Vertical Integration

The vertically integrated gentailer (with ownership of fuel sources of power generation) face complex and serious commercial head winds from:

  • Political activism and retail price regulation – state government commitments to full retail contestability and further reform had an ultimate goal of full retail price competition. Retail price regulation continues in most states (apart from Victoria), and with rising network charges alarming political decision makers, we expect greater pressures on state-based retail price regulators to examine alternative approaches to minimise further increases. With network charges being an effective pass-through, all value and benefits from V are being effectively passed through to consumers. In the medium term, this is likely to distort investment incentives.
  • International gas price parity – from 2015, Australia’s east coast gas market will link to international gas prices. Price expectations range from between $5-7/GJ up to $11/GJ; whereas, historic gas prices attached to gas fired generators range between $2/GJ up to $3/GJ. This step change will, in financial and opportunity value terms, prove to be a headache for VI decision makers that have significant market positions in fuel, generation and retail, particularly, where retail price regulation remains in place.
  • Emergence of consumer-led energy technologies – the average capital costs of solar PV, electric cars, continuous fuel cells, and LNG transport options are declining – rapidly. Many analysts predict that, within the next 5- to 10-year periods, distributed electricity technology will be price comparable to the current traditional electricity supply chain. This change in relative prices, driven by technology change, will collapse current functional segmentation of the electricity supply chain creating more substitutes and competition.

Obviously, the challenge for existing VI players is to maximise current value, and invest strategically. For policy makers and regulators the priority, as it always has been, is to ensure that legal, policy, and regulatory settings remain relevant, and are the least distortionary to participant economic behaviour.