A call for utilities to leave the marketing business.
Many of us on the front lines can identify with Stanley Klein's observation that, in terms of its implementation, the restructuring of the electric power industry is "fundamentally an information technology event."1
Consider all the collaborative groups working on EDI standardization. Building flexible billing systems and capabilities for electronic data interchange makes electric restructuring an expensive and sometimes convoluted task. Think of how much cost this process adds to the final product. All things equal, you wouldn't want to impose that cost on any more firms than is absolutely necessary. But as I contend here, we may be doing just that.
The potential for savings in the final price remains the primary focus for those debating the benefits of competition. If deregulation doesn't increase consumer surplus, why go through the trouble? However, under the pressure to demonstrate immediate price reductions, firms often overlook operational efficiency. To generate consumer surplus, industry restructuring must encourage all firms, both regulated and competitive, to become more efficient in the aggregate.
Are we there yet? Anyone who has mapped an EDI transaction or modeled a new "competitive" business process might well wonder when we might arrive.
The problem, as I see it, lies in the prevailing model for energy retailing. By charging the regulated local distribution company (LDC) with the job of supplier of last resort, we add redundancy to the process. Retailing costs are duplicated in both the regulated and competitive sectors. When the smoke clears, will we realize we overlooked a simple, market-driven alternative for managing operations in competitive electric markets?
The Record So Far
If retail electric markets were roaring to life, the energy industry would offer one more example of man overcoming adversity through technical innovation. But the facts of the matter show otherwise.
The results of restructuring have been mixed. The success of state deregulation programs can be evaluated through metrics such as the number of customers that switch to an alternative energy supplier and the potential savings that a customer could achieve by switching. Figure 1 shows the percentage of customers that have switched in three states on the forefront of restructuring.
Participation levels in California and New York indicate a residential market that is virtually stillborn. Pennsylvania participation numbers show a more robust market, but nothing that would imply a compelling incentive for customers to seek alternative energy suppliers.
In Pennsylvania, residential customers can save as much as 21 percent from the electric generation portion of their utility bills. However, actual savings vary depending on which incumbent utility is serving the customer. When savings are viewed in each of Pennsylvania's seven markets, one for each major distribution company, the results are more ambiguous.5
Outside of PECO's territory, less than half of the suppliers offering energy to residential customers can save customers money. If "green" prices are excluded from the 56 pricing options offered statewide, only 29 of the remaining 47 prices provide savings to customers. Of these, 14 are concentrated between two dot-com utility companies. These data support 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 (QT' , QD' , QE' , QR ).
The four variables are quantities of transmission, distribution, energy, and retail services, respectively. QR 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 (QT' , QD' , QR );
TCS = f (QE' /3, QR /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 = MCLDCR = 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 (RCM) are doubled:
RCM = RCLDC + (3 x RCS) = (wQR + 3 x (wQR)/3) = 2wQR.
Compare that equation with the single retailer model, in which LDC costs become TCLDC = f (QT', QD).
Market retail costs then would return to RCM = wQR.
Even if an LDC wanted to remove itself from the retail arena, it may not be able to do so under requirements that an LDC serve as provider of last resort for all customers. As long as the potential obligation to serve all customers remains with the regulated entity, it makes no sense to eliminate retail infrastructure from the regulated cost base. If relieved of its default service obligations, it might be possible to give LDCs an incentive to end costly retail services through performance-based ratemaking. However, it is more likely that in the short run, new regulation will be required to keep the natural monopoly focused on its mission: maintaining network facilities and reliable delivery of the commodity.
Operational Complexity. Second, the coexistence of redundant retailers shifts each firm's retail cost curve above the original monopolist cost curve. That largely is due to the increased complexity of business functions. Observing the California retail market, Robert McCullough, a professor at Portland State University and managing partner of McCullough Research, wrote, "The complex mechanics and high entry fees simply have made large-scale customer participation impossible."6
Though two parties claim the retail relationship, customers often want one bill for all their electricity charges. Producing one bill for the charges of two retailers, each wishing to track their receivables at an end-use customer level, requires retailers to exchange a significant amount of information. This information exchange usually is facilitated through complex protocols for EDI transactions. These protocols require the exchange of several EDI transactions per customer per month.
Although EDI transactions are effective, they are costly. Fixed costs include the information technology required for EDI and the immense labor needed to define common transactions. New information technologies, such as EDI translators and interfaces with billing systems, are essential infrastructure, required by all firms to be capable of sending and receiving transactions. According to a study by Xenergy, "Utilities report spending from $1.22 to $22 per customer, with one utility reportedly spending up to $82 million to make billing system changes needed to accommodate retail access."7 In addition to IT costs, intensive man-hours are required to define transaction sets and their underlying business processes. This chore is complicated by the difficulties of reaching consensus among all market participants.
New variable costs result from the maintenance of EDI software and the skilled analysts needed to test compliance and resolve data issues with trading partners when communications go awry. According to some estimates, a supplier must spend "$500,000 to comply with a region's EDI standards before selling the first megawatt. In addition, the company will have to spend another $50,000 per utility in the region to meet varying EDI standards."8 There also are network fees such as a price per byte or fixed access charges.
It wouldn't be accurate to claim that a single retail provider would eliminate the demands of information exchange. However, by simply treating the LDC as a wholesale supplier to the retailer, information traffic could be reduced to a few transactions per retailer per month rather than the three or more per end-use customer per month required under current implementation standards.
Missing Incentives. The third disadvantage of the dual-retailer model comes from the lack of incentives for firms to increase the efficiency of their retail services. The lack of incentive is evident in utility cost studies. Although generation and transmission costs have declined during the last decade, distribution and back-office accounting costs have remained flat.9 LDCs embed retail costs in their distribution prices regardless of efficiency. This cost adder prohibits the supplier from offering meaningful retail savings to customers. In addition, suppliers have little reason to invest in large-scale retail infrastructure because the LDC's subsidized back-office infrastructure is provided to them at marginal cost. If retail services were moved entirely to competitive suppliers, increased efficiency could be realized through technological innovation and economies of scale.
Under regulation, the scale of the LDC's regulated territory determines the scale of retail services, QR. As shown in Figure 3, QR is determined by the QD of distribution's natural monopoly.
If transferred to the unregulated retail supplier, QR could be determined by finding the minimum of the average cost curve of supplying these services.
It is true that through mergers LDCs can change their scale. However, the LDCs' scaling is less flexible because their QR is subject to regulatory administration and predefined blocks of franchise territories.
Billing is a Function, But Not a Need
Many restructuring plans across the country provide for the further unbundling of billing and retail services at some point in the future. However, these plans treat retail services as an entirely independent service that, almost as an academic exercise, can be spun off to even more "competitive providers." In fact, retail services should be left in the hands of the supplier of the commodity, because suppliers have the most flexibility in determining their scale. This matter can be understood by considering the nature of the demand for QD', QR, and QE.
Consumers in the market exert a demand to be connected to the electric grid, equal to QD. This demand is not for the sake of connectivity itself, however, but is related to the demand for energy, QE. If a supplier could more efficiently provide electricity with solar cells or fuel cells, then connectivity would be unnecessary and QD would vanish. However, since the network usually is the most efficient means for supply, LDCs fill an important role as a natural monopoly.
Likewise, consumers do not express an inherent demand for retailing services, QR. They do not request to be billed, to have a place to send payments, or to talk to call center representatives, except as a means for receiving electricity. Retail services are demanded by firms in order to offer products and services. In other words, QR is a function of QE. Only the unregulated retailer has flexibility in scaling QE', and therefore they can scale QR such that average retail costs are minimized.
If retail services were moved entirely to suppliers, increased efficiency also could be realized through technological innovation. The recent explosion of Internet services for investment and stock trading is evidence of a large segment of the population that will trade full service for low-cost service, as long as they can participate in the savings. Likewise, technical innovation has the potential to bring about significant downward shifts in the average cost curve of supplying QR. For competitive energy suppliers, innovation is spurred by incentives to increase profits and market share. It is doubtful that the LDC's incentives could be as compelling, since they recover costs and have a protected, heterogeneous customer base.
Electronic bill presentation and payment, or EBPP, could reduce the costs of supplying QR. Cost estimates of EBPP are around $0.40 per customer per month, vs. around $1 for paper bills.10 If customers could elect to forego call center service and shift credit risk to their credit card companies, the potential for cost reductions would rise even higher. That is just one example of potential innovation. Suppliers doubtless would find other cost-reducing services, but only if given the incentive through full ownership of the retail relationship.
Shopping Credits: Politics Intervenes in Pricing
Under current deregulation plans, utility commissions face the difficult and inevitably politicized quandary as to what retail price incentives to establish in the market, i.e., how they should establish the shopping credit. The shopping credit is designed to be sufficiently large to induce competition, but not large enough to send the LDC's customers running for the exit. However, retail price incentives set by regulation are an oxymoron. Experience shows that the parameters of the shopping credit determine the success of the market. California set the credit equal to the wholesale price of electricity with dire results.11 Pennsylvania set higher credits, fomenting the initial success of its market.
At the same time shopping credits are debated, the regulated prices for services, including generation, that the utility provides as the default supplier often are reduced. The combination of guaranteed price reductions and arbitrary shopping credits results in competitive markets without clear price signals or meaningful changes in the retail cost structure. Without complete separation of retail and wholesale functions, determination of prices is a political rather than a market issue. In any scenario in which regulated utilities perform retail functions for hundreds of thousands of customers, it is difficult to imagine that their regulated rates are not subsidizing their retail functions, no matter how much the costs might be unbundled in the tariff itself.
The Georgia Gas Model: A Better Market
One utility that has taken the greatest strides at restructuring is Atlanta Gas & Light. In response to the deregulation of the gas market in Georgia, AGL implemented a far-reaching restructuring plan focusing on delivery.
According to Mark Caudill, vice president of energy competition for AGL Resources, AGL asked two fundamental questions: "What are we doing and ought not to do, and what are we doing that we should continue to do and do better?"
To answer these questions, AGL took a look at all ancillary services and moved all of them that were not essential to the safe and reliable delivery of gas away from the regulated market. If the service is available competitively, the price could be set in the competitive market; if not available competitively, then the price would be set through performance-based rates.
At AGL, functions not integral to delivery, such as meter reading, remittance processing, and billing for 1.5 million customers, were moved to gas marketers and competitive suppliers. Initially there were concerns that billing services couldn't be met adequately in the market, so AGL offered two bill options at regulated prices. However, as Caudill points out, "No one took these offers because it [billing] is a very competitive service." Fewer billing inquiries have allowed AGL to reduce its call center capacity by about half, closing one of two call centers.
As a result of AGL's restructuring, retail gas customers can choose to receive $2.60 worth of ancillary services per bill through competitive markets. Caudill clarifies that the most significant savings come from the better use of delivery assets rather than the unbundling of ancillary services and the commodity, because utilities are committed to cost savings regardless of unbundling. The top benefits to the customer are "control, convenience, and choice."
However, from the perspective of the market as a whole, it is more efficient to have a single point of contact for all of the end-use customer's energy services. Caudill notes, "A network of supra-regional or national marketers can gain economies of scale when they cross the 5 million [customer] mark."
1 Klein, Stanley A., "Silicon Crisis? How Information Technology Poses Risks for Electric Restructuring," Public Utilities Fortnightly, Nov. 1, 1998.
2 California Public Utilities Commission at ftp.cpus.ca.gov/gopher-data/energy-division/dasrs/ToDateFebruary2000_web.xls.
3 New York Public Utilities Commission at www.dps.state.ny.us/Electric_RA_Migration.htm.
4 Information compiled with data from the Pennsylvania Office of Consumer Advocate (www.oca.state.pa.us), listed at www.state.pa.us/PA_Exec/ Attorney_General/Consumer_Advocate/cinfo/instat.html, and dated March 31.
5 Information compiled with data from the Pennsylvania Office of Consumer Advocate, using bill comparisons at www.state.pa.us/PA_Exec/Attorney_ General/Consumer_Advocate/elecomp/pricecharts.html, and dated April 1. The following assumptions were made in calculating the savings presented in this paper: Consumption of 1,000 kilowatt-hours per month during 12 months for a residential customer; residential electric heat rates for PECO and Duquesne not included.
6 McCullough, Robert, "Electric Competition, One Year Later: Winners and Losers In California," Public Utilities Fortnightly, March 1, 1999.
7 Feblowitz, Jill, "Billing Changes Are Most Expensive Back Room Function For Utilities and Suppliers," XENERGY, March 3, 2000, www.xenergy.com/nweb.nsf.
8 Stavros, Richard, "The EDI Solution: Help or Hindrance in Billing and Metering?" Public Utilities Fortnightly, Oct. 1, 1999.
9 Bierman, Sheldon L., Paul A. Nelson, Ph.D., and David F. Stover, "Anomalies in Residential Electric Rates: Harbinger of Competition?" Public Utilities Fortnightly, July 15, 1999.
10 Worhach, Denise, "Online Billing: Savings Oversold?" Public Utilities Fortnightly (Supplement), Spring 2000.
11 Wiser, Ryan, William Golove, and Steve Pickle, "California's Electric Market: What's In It for the Customer?" Public Utilities Fortnightly, August 1998.
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