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Redundant Restructuring: How the Dual-Retailer Model Makes Electric Markets Too Complex

Fortnightly Magazine - July 1 2000

several conclusions. First, meaningful savings can be realized in local residential markets for the commodity itself. However, the limited number of attractive pricing options for residential customers implies that the residential market is of mild interest to competitive suppliers, and the low switch rates suggest that competitive choice is of mild interest to the residential market.

Some would compare deregulated electricity markets to a toddler. First it must learn to walk, later it will grow and run. Another comparison is to an invalid, too sick to flourish. This sickness may be attributed partly to the complexity and inefficiency of market operations, which in turn can be traced to the prevalent restructuring model that guarantees the LDC a retail relationship with the end-use customer.

How Costs Get Duplicated

A competitive model that forces a minimum of two providers to bundle electric services to the retail customer creates inefficiencies for several reasons:

  • Back office costs are duplicated;
  • Business operations are more complex; and
  • Incentives for efficiency are eliminated.

Business Functions. First, the dual retailer model leads to the duplication of business functions. When both the competitive suppliers and LDC perform back-office functions for end-use customers, total firm costs are increased. Before restructuring, one LDC provides all services to its native load. Its bundled total cost function (TC) is a function of several variables:

TCLDC = f (Q T' , Q D' , Q E' , Q R ).

The four variables are quantities of transmission, distribution, energy, and retail services, respectively. Q R is related to the number of customers that are provided retail services such as billing, call center access, and remittance processing.

After restructuring, suppose the energy function is unbundled from transmission and distribution, and three national suppliers divide the energy market. The new LDC and supplier cost functions become

TCLDC = f (Q T' , Q D' , Q R );

TCS = f (Q E' /3, Q R /3).

Next, suppose that in the short run, each firm's marginal cost of providing retail services is equal and constant. After the market is in full operation, the capital costs of building retail infrastructure such as customer systems and call center facilities are sunk. These capital costs can be held constant so that the marginal costs of providing QR is the wage rate.

MCSR = MC LDCR = RC(K,L)/L = w, a constant.

Both the supplier and LDC have similar labor requirements for IT, business, and customer service personnel. As a result, both the LDC and supplier face the same constant marginal costs of labor. The result is that the final market retail costs (RC M) are doubled:

RCM = RC LDC + (3 x RC S) = (wQ R + 3 x (wQ R)/3) = 2wQ R.

Compare that equation with the single retailer model, in which LDC costs become TC LDC = f (Q T', Q D).

Market retail costs then would return to RC M = wQ R.

Even if an LDC wanted to remove