More on vertical integration

Recently I argued that there are good economic reasons why firms vertically integrate. I was arguing this in terms of the recent announcement by the government of their investment plan for broadband. A key feature of this plan in the splitting off of retail services from the orbit of the partnerships that will be charged with delivering broadband. It appears that the government thinks vertical integration is bad, at least for broadband. But the internet isn't the only ares where you see such a view among policymakers. Another common area for anti-integration views is the electricity sector.

Many electricity sectors, including New Zealand's, don't fit the textbook picture of a liberalised market. We see vertical integration between generation and retail often-which is what I guess the government doesn't want for broadband-and contract markets are thin. But is this really a need for competition concern? The short answer may be no.

The textbook view of electricity sector liberalisation is one of markets with many firms competing with each other. Competition is good for efficient pricing and investment decisions and to ensure achieve competition in both wholesale and retail markets policymakers, it is believed, must ensure that generation, transmission, distribution and retail are separately owned, that is, they are 'vertical unbundled'. Once unbundling is achieves, long-term contracts are important for "making the market work" because they help generators and retailers manage risks inherent n competitive wholesale and retail trading and thus support investment. Therefore, the standard story goes, a liquid market in contracts indicates and supports ongoing competition.

Now this view would tell us that there is much reason for alarm in electricity markets such as New Zealand because we have a high degree of vertical integration (mainly between generators and retailers) and not very liquid contracts markets. This, I'm, sure, the Commerce Commission would see as evidence that large integrated players can wield wholesale and/or retail market power. Big is evil!

But is this view misplaced? Does the story told have important limitations?

Fortunately to help answer these question the March 2009 issue of ISCR Competition and Regulation Times, put out by the New Zealand Institute for the Study of Competition and Regulation, contains an article on "(Some) vertical integration may not be so bad after all" by Seini O'Connor and Richard Meade.

They point out that recent research challenges that ideas that high levels of contracting and competition are essential for good market outcomes. In fact excessive retail entry could undermine the viability of the contracts that are assumed to promote competition. This will, in turn, threaten investment in generation and supply security. The problem here is that a retailer who enters into a long-term contract at an agreed price is at risk of other retail competitors entering later at lower wholesale spot prices. This increases the risk that our original retailer will renege on his contract or that he will lose market share to the new entrants and in the extreme case go under. There is a similar problem for industrial customers who agree to make direct electricity purchases. They face output market competition and face problems if they cannot pass the high contracted for electricity price on to their customers.

Anticipating these risks incumbent retailers and generators will enter into fewer long-term contracts, than would otherwise be the case, ans this reduction is contracts will result in risk-management, investment and security of supply falling below their efficient levels.

What can vertical integration do about this? Allowing generators to vertically integrate downstream into retailing or allowing large industrial consumers to integrate upstream into generation is possibly a better answer than yet more regulations or franchises when facing deficient contracting. O'Connor and Meade argue there are three important advantages that vertical integration has over fully-unbundled markets that reply on contracting. They write,

It protects against hold-up risks resulting from excessive entry. By thinning contract markets, vertical integration immediately reduces the scope for retail-only entry, since any new entrant of scale would need to also invest in generation capacity. Furthermore, generators (and hence gentailers) are often much larger and more diversified than retailers -so even if new retailers do enter the market, they will only be able to access limited contract capacity (a mere portion of a generator's customer base). This automatically reduces a gentailer's exposure to hold-up and failure, should the new-entrant retailer succeed.

It marginalises the integrated firm's exposure to wholesale price risk and reduces incentives to exercise wholesale market power. Since the role of contracting under vertical integration is reduced to covering any remaining uncommitted or over-committed capacity,wholesale prices play a much reduced role and hence the level and volatility of wholesale prices are of less consequence.

It enables a better matching of capacity and demand characteristics. Vertical integration can provide a better long-term match between generator and customer preferences on supply security and load matching. For example, retailers who fear short-term wholesale price spikes, and who can't enter into contracts to hedge against these, can instead invest in peaking plant. Similarly, large customers with unusual or seasonal load profiles (such as dairy or pulp-and-paper processors) can invest in co-generation plant whose output correlates with their
production patterns and affords them greater control over supply security. (p. 5)

These attributes means that, compared with contracting, integration is better at managing any wholesale price risks. Moreover, vertical integration does this on a secure long-term basis. Effective risk management is achieved via contracting only for the horizon of the contract; beyond the period of the contract, the contracting parties are exposed to renegotiation risks not shared to the same degree by integrated firms. Internalising the limited wholesale price risks to the firm thus provides a more durable hedge.

Vertical integration does decrease the scope for retail-only entry, however it does not preclude retail entry per se. What is does do is it changes the way that such entry happens: new retail entry is driven more by generators undertaking capacity expansions and extending into retail and, in some infrequent cases, by wholly new 'gentail' entry. Vertical integration cold even be somewhat better than long-term contracts at supporting retail competition, because it diminishes wholesale price and retail hold-up risks.

Overall the point is that vertical integration is not the concern that some, in the government at least, seem to think it is. Such integration can diminish the use of wholesale market power and sustain retail competition. In doing so it also acts as an effective solution for managing markets risks while supporting supply security.

An important point for policy makers, when thinking about broadband, is that vertical integration arises endogenously even in systems with relatively liquid contract markets. This suggests it has a natural and important role to fill in not only electricity systems but may be also in other areas with similar market structures. Broadband could be one and so there may be lessons here for the government.

Note: The O'Connor and Meade article discussed above is based on their article "Comparison of Long-Term Contracts and Vertical Integration in Decentralised Electricity Markets". (pdf)