Did increase in competition help make better electricity markets and lower prices?

Adam Swadley and Mine Yücel of Dallas Fed write this nice paper on the topic. It is always great to read such papers on competition and efficiency.

The paper focuses on retail electricity market. In 2000s US reformed its retail electricity market and allowed competition. People could choose their suppliers and so on. What was the impact of such reforms? Did it help consumers? Did it lower prices?

This paper looks at these issues.

Electricity market restructuring has received significant attention in the energy economics literature, particularly in the mid-2000s after many states restructured their electricity markets and offered retail choice. A key selling point for the restructuring of electricity markets was the promise of lower retail electric prices, that competition among independent power suppliers to lure customers from the incumbent utility company’s default or “standard offer” service would lower prices to retail customers.

So far studies have differed on whether it helped (as usual with economics):

There is no consensus among earlier studies on how restructuring affected retail prices. Zarnikau and Whitworth (2006), Rose (2004) and Joskow (2006) note that large commercial and industrial customers have realized some cost-saving benefits from competition, while Apt (2005) concludes that competition has not lowered electricity rates for industrial users. Joskow (2006) finds retail competition lowers both residential and industrial electricity prices, but attributes the price decline to non-market artifacts of restructuring legislation and regulated default service rather than competitive forces. In a study focusing on the residential market in Texas, Zarnikau and Whitworth (2006) show that electricity rates rose faster in areas of the state that were open to retail competition than in areas that were not.

It is important to note that the timing of many of these earlier studies of electricity restructuring was such that many of the states offering retail choice to residential customers had regulated default service, transitional pricing mechanisms, or other  rice controls in place. These temporary price controls varied across states, but their common purpose was to protect consumers and power generators from price volatility in the transition to a competitive market .

There are both kinds of issues here. Some states had artificial low prices. In that case prices went up not because of anything but inefficient markets earlier. Then the period was marked with price hikes in fuel leading to higher electricity prices. So, how does one differentiate these factors? This paper helps as we  have some years since the transition has happened. Then it also looks at states with different fuels and how each one responds.

In this paper, we use panel data to study 16 states and the District of Columbia that started retail competition in the late 90s and early 2000s, and have mainly completed their restructuring and ended their transitional prices. Among these states, only California and Virginia have suspended retail competition for residential customers. Given that transitional pricing ended several years ago in most of these states, we have several years of data to study the effects of retail competition. We contribute to the literature in a couple of ways. We estimate the effects of retail competition and transitional pricing on residential electric rates, using Texas as a baseline and estimating separate effects of these policies for individual states in our panel where possible. The second major contribution of this paper is to estimate the effect of increased residential customer participation in a competitive markets on residential electric rates.

The broad findings are:

  • An increase in participation rates takes some time to be reflected in lower electricity prices.
  • We find that an increase in participation rates, price controls, a larger market, and high shares of hydro in electricity generation lower retail prices, while increases in natural gas and coal prices increase rates.
  • The effect of moving to a competitive retail electricity market is mixed across states, but generally appears to lower prices in states with high participation and raise prices in states that have little customer participation.

More specifically, states differ. Maine is a classic example of reforming its wholesale market first. There is a competitive auction process for its wholesale market leading to lower rates before entering retail market. Hence, despite lower participation of people, its rates are lower:

  • For Texas, Connecticut, Maine, and Pennsylvania, moving to a competitive retail market lowers retail prices. Texas, Connecticut, and Pennsylvania have relatively high participation rates, and Pennsylvania still had some price controls in place  over our sample period. Although the participation rate for Maine is low in Table 1, Maine’s restructuring initiatives differ from many other states and a very high percentage of Maine customers essentially get their power through a competitive market. The incentive for Mainers to choose a competitive retail provider is limited because Maine’s standard offer service generation is already procured through a competitive bidding process. This keeps prices low and eliminates both the incentive for residential customers to choose a different provider and for competitive retail providers to serve residential customers in that market
  • For the remaining states, the switch to retail competition did not necessarily lower retail prices. For CA, DE, IL, MD, MI, NJ, and DC, having a competitive market actually appears to have raised rates while MA and NY have statistically insignificant  coefficients, implying no  change in retail prices in these states. It is possible that the participation rate, which starts rising after transitional pricing is eliminated, is picking up much of the effect of restructuring, as would be expected if price decreases are driven by competitive forces. The significant (and largely positive) coefficients on retail competition in states with relatively low participation suggest that higher rates of participation in the retail market are necessary to successfully lower residential electric rates.

Lessons are market design is crucial:

Our results show that none of the retail electricity market designs yield instant price reductions for customers. States that held prices artificially low during the transition to a competitive market may have seen lower prices initially; however, the long-run  effect of artificially depressed prices is a misallocation of resources and an inefficient electricity market. Consumers have no incentive to switch to an alternative electricity provider and providers have no incentive to enter the market to serve residential customers.

A successfully designed market must provide profit opportunities for providers as well as incentives for consumers to switch providers. Although this may result in higher-than-desired rates initially, in the long-run intensified competition is more to likely yield sustainable lower rates. An alternative seemingly successful approach is to procure standard-offer electricity services through a competitive bidding process, as in Maine. This approach does not have the dependence on retail customers’ participation, but still has the potential to yield some level of benefit resulting from competition.

Overall one does not see much lower rates because of choice of fuel (some states depend on gas and coal for generating electricity leading to higher prices) and lower participation of people. This is interesting. Despite choice of getting lower prices, people do not participate. They are not rational as we always assume. Some nudges might be needed.

Apart from lower rates, this system could be used to change and match choice of fuel:

If increased generation from alternative fuels is a policy goal and there are consumers demanding electricity from alternate fuels, a competitive retail market can match these customers with their suppliers. As Roe et.al. (2001) note, an increased willingness to pay for electricity generated from renewable fuels suggests that a competitive retail market may be one step in achieving renewable energy goals.

Superb paper. Has so many insights on microeconomics.

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