Fortnightly
Unbundling Electric DiscosOverseas and At HomeExperience shows it can work. But at what cost?
April 01, 1998
By Ahmad Faruqui and Laurence D. Kirsch
As the U.S. electric power industry unbundles, the industry and its regulators grapple with two big questions concerning the degree to which distribution services should be unbundled. First, what groups of distribution activities can separate suppliers provide? Second, which of these groups of activities should be open to competition?
Looking at the unbundling experiences of Argentina, Australia, Canada, Chile, Norway and the United Kingdom sheds light on these questions. The distribution unbundling of the U.S. gas and telecommunications industries provides additional insights.
So, what can the U.S. electric power industry learn from these experiences? First, distribution can be unbundled \(em for a price. Distribution unbundling raises questions of coordination and responsibility. Who's responsible when the lights go out? International experience shows that incentives affect market participants' willingness to invest in new distribution facilities. Finally, unbundling benefits consumers through new and better services; but these benefits usually mean higher rates and increased complexity.
International Power Experiences
Table 1 summarizes some key characteristics of distribution service unbundling in the six nations in this survey. The table shows at least two striking facts. First, half of the respondents have not unbundled distribution services \(em and do not intend to do so. Second, those nations that have unbundled services, with the exception of Chile, have done so only very recently. (The Chilean exception is not very important, however, as its unbundling has been very limited.) The second striking fact is that, even in the nations that have unbundled distribution, those services account for only a small share of distribution costs.
Survey respondents are reluctant to unbundle distribution because they have found it difficult to identify sensible schemes for separating services. They fear it would impose a huge cost on consumers. Most respondents believe consumers would benefit marginally from unbundling.
The Norwegian respondents suggest that distribution unbundling is occurring for ideological, not economic reasons. Indeed, the Australian and U.K. respondents indicate they're unbundling primarily because of government policies to promote competition; they only vaguely believe that competition will benefit consumers.
The Australian and U.K. respondents report that technological problems do not pose insurmountable barriers to distribution unbundling, but that they do add to cost and time requirements. They are concerned with metering, billing and information-handling technologies. They indicate that introduction of competition is easier if it is staged to allow sufficient time to implement the new information systems and infrastructure necessary for handling competitive market transactions.
The survey respondents recognize a slew of potentially unbundled distribution services. These are listed in Table 2, which divides them into (a) facilities services, (b) revenue cycle services and (c) energy services. Facilities services are provided by equipment throughout the distribution network, but sometimes are unbundled when provided by equipment on or near a customer's site. Connections and line-drops services connect the customer's load to the power system either through a standard single connection path or through an enhanced double path that reduces chances of customer outage. Transformers, power factor corrections and premium power quality services control the quality of the power received by the customer and also control the effects of the customer's load upon the power system. Meter installation service provides the equipment that measures the customer's use of power. Revenue cycle services include the meter reading and billing services that occur on monthly schedules and less-regular customer contact services. Energy services are debatably not a part of the distribution function at all, but some respondents nonetheless include them among distribution services.
Table 2 indicates the unbundled services that may be obtained from competitive sources in each of the responding nations. But unbundling also occurs without opening services to competition. For example, the Canadian and Norwegian respondents report that some services once offered as part of bundled distribution service, like energy audits or extra transformers, must now be purchased separately by the customer. Customers in Argentina and Chile must purchase line maintenance, meter reading, customer connection and billing services through their local distribution monopolies; but, to better control costs, these monopolies have adopted the practice of purchasing these services from subcontractors through competitive processes.
Unbundling has led to the introduction of new services, some of which are listed in Table 2. For example, new services in Australia include improved power quality control, sub-metering, energy analysis and reporting, lighting, power factor corrections, and consulting and financing services to customers who install energy-saving equipment.
The meaning of "unbundling" can vary among nations, even for a single unbundled service. In the U.K., for example, the installation of new assets like connections, transformers and meters is competitive; but once installed, the maintenance of that equipment becomes the responsibility of the distribution monopolist. A different unbundling scheme could make the customer who benefits from equipment responsible for equipment maintenance.
Market Power Problems;
Customer Benefits?
Survey respondents report disparate market power issues. Some claim to have serious problems, while others say they are free of any such difficulties. Differences appear to arise from market organization. Consumer benefits are less clear cut, however. While respondents report that deregulation has led to dramatic drops in electricity prices, the effects of distribution service deregulation and unbundling is not so obvious. Here's a breakdown:
ARGENTINA. Distribution companies are subject to a form of incentive regulation that encourages them to lower their costs. It is hoped that this will lead to lower consumer prices.
AUSTRALIA. Market power is not an issue. Competition in generation services is robust, while distribution companies remain tightly regulated. Australia has seen electricity prices drop, but service quality has stayed the same or improved, and customers have gained some control over their power service. Most gains have occurred in generation services, but distribution companies also have become more efficient. Customers seem willing to pay for extra power services that improve power quality and reliability not only for themselves but for their neighbors as well. The continuing regulation of transmission and distribution assures adequate investment in power transportation infrastructure.
ALBERTA, CANADA. One generation firm has a 60-percent market share in Alberta. Some question whether this firm has the power to influence market outcomes at the distribution level. Incentives that discourage investment in power transportation infrastructure may harm service reliability and ultimately increase costs. This situation may occur because transmission facilities are built by the transmission company only when it has a contract from a distribution company, but distribution companies will sign contracts only if they have the necessary customers lined up. Customers, meanwhile, will promise to pay for infrastructure only at the last minute, if then. This is a classic free-rider problem wherein everyone wants somebody else to pay for investments that provide benefits to all. Alberta is already experiencing transmission congestion; it is likely to get worse.
CHILE. Severe market power problems arise from the huge cross-ownership between generation firms and transmission and distribution firms. Because of the high concentration of ownership in generation, market power problems in generation are mirrored by those in distribution. Chile's worst market power problems allegedly afflict its metering services. Chile's local distribution monopolies own and control the metering industry. They are said to collude (implicitly) in dividing the metering market among themselves and thereby restraining metering competition. They impede new entry by independent metering firms, arguing that these new entrants cannot properly calibrate meters. Because metering services are not price-regulated, the distribution monopolies exercise monopoly power when setting their meter service prices. Chile's market power problems are leading to a political reaction against distribution service unbundling. Experience has led to the view that distribution services cannot be competitive and that they should therefore revert to full regulation. These problems may have disaffected consumers. In particular, customers complain they are charged for non-existent services, such as "meter maintenance" that never occurs. The distribution companies say these complaints are arbitrary.
NORWAY. There are numerous local distribution companies. Each has a local monopoly and is governed by incentive regulation. Some observers believe that incentive regulation has minimized any problems of market power in distribution services. Other observers believe that vertically integrated power companies sometimes use their distribution subsidiaries' monopoly status to subsidize their non-distribution subsidiaries.
UNITED KINGDOM. Regulation severely limits the market power abilities of local distribution monopolists. There is, nonetheless, some question about whether the distribution companies cross-subsidize their affiliates, which is an illegal practice. Restructuring generally has improved service quality for customers. Appropriate distribution investments are being undertaken because distribution companies are subject to regulation that offers reasonable assurance of recovery of prudently incurred investments. Restructuring has significantly reduced prices for large customers. Part of this benefit is due to the improved distribution service efficiencies that have accompanied industry restructuring. But the price reductions ultimately offered to smaller customers are likely to be less significant than those offered to larger customers. This will occur partly because of the relatively higher distribution costs of serving smaller customers.
Telecom & Gas Lessons
Of the many U.S. industries that have deregulated in the past two decades, gas and telecommunications are most likely to offer the keenest insights into the possibilities of electric distribution deregulation. Table 3 indicates that these industries have been deregulated for several years longer (and to a greater extent) than most of the international electricity industries. Telecommunications distribution services are on their way toward complete unbundling, which is now mandatory in urban areas, and a few years away in rural areas.
The unbundled distribution services of the gas industry are recognizable to electric industry observers. These services include firm transportation, interruptible transportation, storage, metering and billing services. Except for storage service, these are all transportation services that will be offered and likely unbundled in the electric power industry. (In electricity, storage service is likely to be offered by generation and/or merchant firms rather than by transportation firms.)
The telecommunications industry's unbundled distribution services are a different story. These include local loop, transport, end-office switching, tandem switching and interexchange carrier access services. Local loop and transport services are analogous to electric distribution wires services. Switching services are specific to telecommunications technology and are vaguely analogous to power system scheduling and dispatch service. Interexchange carrier access service is not a service but instead a cross-subsidization scheme similar to the transition charges that will prospectively be levied by some electric utilities.
The deregulation of the gas and telecommunications industries were undertaken to promote competition, encourage technological innovation, encourage service innovation, improve service quality and lower prices. In the gas industry, there was motivation to improve the allocation of underutilized transportation and production resources. In the telecommunications industry, deregulation is focusing on achieving all of these benefits at the distributor level.
Gas has had few technology barriers during unbundling; technology has posed more significant roadblocks for telecom. For gas, market values vary by month and sometimes, near the annual peak load, by day. Gas does not face the metering and billing problems that afflict the unbundling of electricity services. For telecom, on the other hand, it is difficult to determine the physical locations at which unbundled services may be distinguished from one another. These locations change over time with evolving technology. Furthermore, telecom services may be more expensive when unbundled than if left bundled.
Market power problems have been limited in gas and telecommunications distribution because local distribution firms all have remained tightly regulated. The chief problem in both industries has been one of monitoring the cross-subsidization of transactions between the regulated firms and their unregulated affiliates. In the telecommunications industry, cross-subsidization is being mitigated through structural separation of regulated and competitive affiliates or price regulation that forces prices to equal incremental costs plus some share of joint costs.
Gas deregulation resulted in lower, but more volatile, gas supply prices. This volatility has led to the development of financial markets and instruments to hedge price risk. Investment by regulated transportation firms has generally been adequate, so service reliability has remained good.
The overall effect of telecom deregulation has produced lower prices for consumers and a wider variety of services. At the distribution level, however, it is too early to tell if unbundling will reduce prices or affect quality. Competition has realigned prices among distribution services. Prices may increase and reliability may falter if, as some observers believe, competitive entry and investment are proceeding at too slow a pace. Customers seem to find unbundled billings inconvenient, and may prefer one-stop shopping.
A Lesson for U.S. Unbundling
From these examples it is clear that distribution unbundling is technically feasible but may prove costly. The main technical challenges lie in information management. Development of standards and procedures that are widely acceptable to market participants are critical, but the real costs lie in the metering and software infrastructures that will be required to implement those standards and procedures. U.S. power firms should note that in the U.K., where open access was phased in gradually, there was a time when billing systems broke down completely. Consequently, utilities lost money settling customers' bills.
Distribution unbundling raises questions of coordination and responsibility. Unbundling may split responsibilities among power firms in confusing ways. For example, when the lights go out, does the customer call the power supplier or the local distribution firm? If independent contractors build customer facilities that the local distribution monopoly must thereafter maintain, do the independent contractors have incentives to cut costs by providing shoddy equipment? Does the local distribution monopoly have incentives to blame independent contractors for high maintenance costs?
Investment incentives matter. International experience indicates that incentives affect market participants' willingness to invest appropriately in new distribution facilities. In jurisdictions where investments are determined through purely market processes, free-ridership leads to underinvestment in transportation facilities and to problems of congestion and reliability. In jurisdictions where the distribution monopolists are granted a reasonable opportunity to recover prudently incurred costs, there is adequate investment in transportation facilities.
Unbundling can encourage innovation in management of services; thus encouraging cost and price reductions. It can also encourage the introduction of new services.
Nevertheless, distribution unbundling might be bad for consumers. Unbundling may raise the costs of coordinating the provision of various services that together comprise delivered power. It may encourage the development of billing systems and the installation of equipment (notably meters) that have costs in excess of value. It may complicate consumers' buying decisions. Moreover, unbundling will lead to cost-shifting that is likely to reduce the bills of large consumers while increasing the bills of small consumers.
Ahmad Faruqui, Ph.D., technical manager in the Retail & Power Market Tools Target of EPRI, in Palo Alto, Calif., is leading research to help energy companies develop competitive retail pricing products. Laurence D. Kirsch, Ph.D., senior economist with Christensen Associates in Madison, Wisc., has specialized in economic analysis of electric power system cost structures, bulk power markets, power pool operations, and pricing. The authors wish to thank Cesar Herrera, Lawrence Kaufmann, and Mark Meitzen for their contributions to this article.
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