Do we need another contestable market, or a market that’s more contestable?

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Is there a lack of meaningful competition in the electricity retail sector?

The idea of Contestability has been topical lately. One of the AEMC’s many Power of Choice review recommendations is the creation of a new contestable market for Demand-Side Participation (DSP), alongside the existing contestable market for energy retailing, so that providers of demand management can compete to offer their respective services directly to customers.

DSP service providers typically purchase the right to curtail load from customers, aggregate it, and resell it as a demand reduction service to distributors and the electricity market (although as yet we have seen no players that are truly independent of existing networks or retailers). These providers have focused on commercial and industrial electricity users, but are expected to expand to the residential market as it becomes more economical to do so. Residential customers will then have another field of competitors for an energy-related service to choose from.

These developments may seem reasonable, since the rising price of electricity over the past decade, combined with somewhat moribund product offerings in the sector, has left households and industry frustrated. However, they point toward a theoretically efficient but practically complex system where customers establish multiple relationships with different varieties of financially responsible market participant (FRMP), which each compete in their partially separate markets.

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Figure 1: Parallel Contestable Energy Service Provision Markets

How much choice is too much?

Customers already have significant energy choices to make between retailers, and between other service providers. The emergence of a new market for independent Demand Management would add to these choices, but would also require complex market institutions and interactions to govern contestability in DSP. This will be an expensive reform to establish and maintain, and will likewise create new compliance costs for the businesses who work under it (for example, retailers and distributors are likely to need a system overhaul to cope with “full demand competition” (e.g. an upgrade in MMS capability), similar to what was needed to cope with full retail competition.

More to the point, we believe this system passes the threshold of “too much choice”, and will create complexity and confusion in customers’ minds rather than relief. A recent survey by consumer group Choice, non-profit group the Brotherhood of St Laurence and the Energy Efficiency Council found that customers already find it difficult to compare the “confusing array” of offers from energy retailers.[1] It is hard to imagine these customers being engaged enough to make a series of choices about multiple types of energy service provider, where it is not immediately clear how each provider may compliment or interfere with the next.

Elsewhere in Australia, we have seen the failures of over-engineered markets to deliver meaningful competition and choice, despite significant investments being made on the necessary frameworks, systems and processes to implement contestability:

  • The WEM in Western Australia is still dominated by one retailer and one generator, and there seems little prospect of improvement.
  • Full retail competition nominally exists in the Northern Territory. However, PowerWater effectively still controls the market as a regulated monopoly and, due to subsidised bills and the poor economics of supplying energy to all but a handful of customers, no competitors have been able to challenge it.

With that said, competition in electricity retailing itself has on the whole created real and measurable benefits in the NEM and elsewhere in the world, as basic economic theory predicts it should. So what does this suggest about the best way to create these benefits in energy-related services?

Innovative retail entrants are a better alternative to multiple markets

In our view, even if a new market is created for DSP, the most likely outcome is that energy retailers will compete with each other in their existing market to provide a ‘one stop shop’ to customers that packages metering, DSP, microgeneration, storage, and other equipment and services – rendering the new market largely superfluous.

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Figure 2: A Full Service Energy Provider that can offer customers an integrated set of energy products, with one point of contact.


Here, we have conceived of a retailer which goes beyond simply satisfying customer energy demand, and which would make use of customer data to give them the optimal combination of network-delivered energy, locally-generated energy, demand management, energy efficiency, etc. We have unimaginatively termed this a “Full Service Energy Provider” (FSEP).
Figure 2: A Full Service Energy Provider that can offer customers an integrated set of energy products, with one point of contact.

Why do we believe this model is likely to prevail?

  • It makes choice manageable and life simple for customers – they only need to select and deal with one energy provider.
  • An FSEP acting as a customer advocate in optimising the combination of energy and energy services offered, should be able to offer a lower-priced package than could be offered by a disorganised set of competitors with overlapping products.
  • It requires no intervention from rulemaking bodies or additional costly market reform.
  • It does not impose costs of new systems on market participants (beyond what they voluntarily decide to set up)

These factors above also suggest that retailers who adopt the FSEP model will have a competitive edge. This in turn suggests that this model, shown in Figure 2, will grow organically if allowed to and will eventually displace the currently dominant model of volume-driven energy sales. In doing so, it will also obviate the AEMC’s suggested model shown in Figure 1.

Meaningful retail competition is about to emerge

Many may wonder why this full-service retail offering hasn’t emerged sooner, if (as we argue) it would give its bearers a competitive advantage. Indeed, at a time of declining wholesale energy prices and diminished NEM price volatility, it is easy to reflect that the option for DSP was more attractive at any previous period in the NEM than it is now. So, why is this now gaining momentum?

Since the 1990s, the NEM has been dominated by an oligopoly of generator-retailers motivated to maximise the use of their generation assets through energy sales. Arguably, they have not been driven by customer needs beyond simple energy supply, and thus have offered largely identical products, with little sign of (or drive for) innovation of the kind we’re suggesting here.

However, we believe the market is on the cusp of a change that will destabilise this historically dominant value proposition; and, if the current oligopolists do not respond, it will open the way for FSEPs to acquire market share:

  • The relatively new RIT-T and RIT-D tests require network businesses to examine all reasonable options to meet customer demand, including demand management solutions (whereas previously they were in practice allowed to respond through continuous capital augmentation by default). At the same time, these utilities are finding capital difficult to secure from their owners and financiers. This will create a new and material class of purchaser for demand management offerings.
  • Smart meter technologies, which enable (or at least greatly facilitate) demand-side participation, are now universally rolled out in Victoria, and elsewhere are available more cheaply than ever.
  • The price of energy has risen to a point where customers are no longer indifferent between retail offers.
  • Examples of successful integrated energy retail / demand management offerings from elsewhere in the world (e.g. from the major investor-owned utilities in California) are now available to draw lessons from.
  • It is possible (though unprovable) that the prospect of an independent market for DSP has stimulated energy retailers to formulate and offer more diverse choices.

And in actuality, new retailers with a “full service” model are already entering the market with phenomenal success (for example, we have observed a start-up retailer servicing larger businesses offering everything from financial hedging strategies to physical operational energy management).

Demand Contestability: Not really necessary after all?

Despite the poor competitive dynamics of the energy retail sector in the NEM to date, retail per se is not the problem. New FSEPs with a genuine customer focus will enter the retail market; new products and services stemming from better data and technology will appear; meaningful and more diverse forms of competition (which already exist in a nascent form) will inevitably emerge; and the existing retail market will optimally serve customers’ needs, without the need for the contestability reforms proposed by the AEMC.

In summary, we suggest that the proliferation of contestable markets, like most good things, is best in moderation. Customers want simplicity in their choices. We fear that the model of contestability outlined in the Power of Choice review will not deliver meaningful competition, nor material efficiency gains for all but the largest and most sophisticated energy buyers, who in many cases already have more diverse options.

All that needs to change, in our view, is the dominant business model for energy retailers. And it is already starting to happen.

 

[1] Source: http://www.businessspectator.com.au/news/2013/12/2/policy-politics/electricity-scariest-cost-aussies