Jim Waddell,
Pricewaterhouse Coopers, USA

Sometime early in 2002, more than half of the households in the USA will have the ability to choose their supplier of electricity, gas, or both. This is a significant milestone along the path to full competition in the utility sector. A decade ago, it was difficult to imagine that retail choice would be widely scheduled for adoption. Yet, it is also increasingly apparent that retail choice and retail competition are not the same.

Without more active competition the expected benefits of choice will not be achieved. The halfway point to full retail competition for electricity is nowhere in sight.

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Despite the increasing prevalence of retail choice, there are few markets where competitive forces determine retail prices. During 2000, several US states saw competing marketers return their customers to the incumbent electric utility, as they found it impossible to sell electricity at a rate below the regulated price. In California, the incumbent utilities are incurring enormous losses, as they are required to sell electricity at retail prices well below prices charged in the wholesale market. The regulation of retail prices has created an enormous barrier to the emergence of market forces.

Market rules were created in most states to ensure equal competition between of the incumbent utility’s retail affiliate and new entrants. These rules are admirable in intent, but they have forced virtually every retail organization to be a start-up organization. Most retail affiliates are small and under-capitalized. They need to make substantial investments in marketing and customer care systems, yet have very limited revenue streams. As a result, most have little staying power outside their own original territory.

Market rules

A more significant barrier to entry has been the inconsistent regulations accompanying retail choice in the states where it has been adopted. With different market rules emerging in each state, a plethora of rules has emerged and increased the transaction costs associated with selling retail electricity. Many potential entrants— especially retailers from outside the industry— are discouraged by the cost of setting up systems for marketing electricity and serving customers. Competition so far has been limited mostly to the industry’s traditional participants.

The inability of electricity retailers to grow limits competition and the benefits of competition. Price-waterhouseCoopers has estimated that a minimum of five million customers is needed to spread the costs of a retailer’s system over a large enough base to provide cost-effective service. But today it is nearly impossible to find a group of five million customers that are subject to the same set of market rules. The retailer’s costs are increased and customers shoulder these costs.

The failure of large, nationally branded suppliers to enter the retail electricity sector is understandable, given these barriers. Competition is mostly identified with the incumbent utility supplier and has limited marketing appeal. The most obvious consumer response has been apathy. None of the retailers in the electricity sector has yet developed a brand or a business model that has captured the imagination of consumers.

Customer apathy has made it difficult to interest consumers in retail choice programmes and the different companies that will be involved in the restructured sector. Without this knowledge, however, consumers overestimate the risks associated with electricity supply and see the incumbent as most able to minimize the risks of electricity supply. In the absence of any compelling consumer interest, with regulated prices often below the cost of wholesale supply, and with consumers over-estimating the risks associated with switching suppliers, it is little wonder that the incumbent utility and its retail affiliate often “win” the vast majority of available customers.

While the current state of industry restructuring has not yet produced the potential benefits of competition, there are encouraging signs of increased movements toward greater competition. We would also do well to remember that the restructuring of the telecommunications sector— which is now aggressively competitive, with continued reductions in price and product and price innovation— took several years before the near monopoly position of AT&T began to erode. Similar movements can be expected in the electricity sector, if pro-competitive regulations are adopted.

The Internet

The outlines of several national retail players are beginning to emerge. Some of the Internet-based pure-play retailers, such as essential.com and Utility.com, have gained considerable visibility. Both have modified their business models to act more on behalf of incumbent utilities and serve as their Internet retailer in their traditional service area. Both offer a variety of services to homeowners, such as telecommunications, Internet access, energy and other products.

MyHomeKey.com, an offer of KeySpan and Texas Utilities, is attempting to bundle many of these same services with other home conveniences, such as plumbing and HVAC services. The most widely discussed new offer in the mass market arena is that of The New Power Company, a venture developed by Enron, in association with IBM and AOL. Fuelled by the extensive Internet presence of AOL, the trading and risk management capabilities of Enron, and the back-office systems capabilities of IBM, this could be a formidable collaboration.

There are numerous business plans, developed by many of the major energy utilities, waiting for execution when market conditions are right. Many of these plans include a wide array of services to be offered and a variety of channels to the consumer. In addition, there is the potential entry of European utilities with their models of retail competition and offers of bundled services into the home.

Beyond the potential entry of national energy retailers into the sector, there are many businesses considering whether to enter the market and provide services to these retailers. Many businesses are being created to provide specific services in the retail electricity market such as billing, metering and meter data management. It is also reported that a large amount of venture capital is being invested in the electricity sector, mainly in the areas of technology— such as fuel cells and distributed generation— or the development of market infrastructure— such as metering and billing systems. Obviously, these ventures will be successful and widely implemented if the underlying retail market is truly competitive. The interest and investment in these ventures is a clear indication that some market participants are betting that the market will be successful.

Real value

There are enormous opportunities to create value in the retail market. A notable feature of the newly competitive wholesale markets has been widely fluctuating prices and price spikes. A retail company that is able to develop a better wholesale buying strategy and work with its customers to modify their load patterns can create real value. In fact, the existence of these price spikes is evidence that competitive forces are not sufficiently strong in the market.

If end-use customers really had to pay the prices that have been charged for wholesale power, there is no doubt that the market would clear at much lower prices. These wholesale prices can only emerge because consumers are insulated from actually paying them. In a truly competitive market, retailers would create value by trading around customer’s loads and avoiding purchases during the highest cost hours.

This value will soon be enhanced with the advent of in-home dispatching of appliances — the use of micro-processors embedded in the appliances that enable the utility to monitor usage, cycle on and off the appliance, and in some cases identify the need for maintenance. The widespread availability of these devices will eventually enable retail suppliers to create new products and pricing programmes for residential and small commercial customers— creating value and profits in the process.

Many of these new business models depend heavily on the Internet and information technology. The Internet is an important channel for marketing and servicing large numbers of retail customers cost effectively. In fact, the business models of most national entrants will depend to a great extent on the cost advantages of the Internet.

Similarly, the business model of many retailers selling to large commercial and industrial customers depends on the widespread availability and dissemination of information over the Internet. Load control, equipment maintenance, and in-home dispatching of service will all become feasible only through sophisticated Internet applications. As a result, success in electricity retailing will depend heavily on the technology capabilities of the supplier.

There is enormous potential for electricity retailing to create value in the sector and, by extension, profits for retailers. For this to occur, full-scale retail competition needs to emerge. Significant investments and participation of major players will be forthcoming when a national pattern of market rules is developed, enabling entrants to take advantage of economies of scale.

These rules must allow for market forces to determine prices; regulated prices below the cost that entrants will change will only discourage competition. Widening market rules to allow national players to develop scale will result in the type of vigorous competition that is advantageous to consumers.