An attempt to lower NZ electricity prices could end up doing the opposite – here’s why

In its quest to lower electricity prices for New Zealand households, the Electricity Authority may inadvertently make the situation worse.

This week, the authority announced plans^[1] to require New Zealand’s “gentailers” – firms that both generate electricity and retail it to consumers – to offer the same supply terms to independent retailers as they do to their own retail arms.

The aim is to prevent the gentailers from providing discounted electricity to themselves, thereby levelling the playing field between retailers, to deepen competition and lower prices.

Yet while greater competition and lower prices sound appealing, such expectations rest on a naïve understanding of how New Zealand’s electricity market works.

Upward pressure

Under current rules, New Zealand’s gentailers – notably Genesis, Meridian, Mercury and Contact – can supply their own retail arms at prices that reflect their cost of generation, which is typically lower than the wholesale market price.

Retailers without generation capacity must buy electricity at these higher wholesale prices, making it hard to compete with vertically integrated gentailers.

The authority expects gentailers to offer all retailers – including rivals – the same low prices they give themselves.

But no firm wants to offer rivals the lower prices that come from investing in the infrastructure to generate power themselves.

Instead, the proposed rule could induce gentailers to raise the price charged to their retail arms – thereby pushing up retail supply costs for everyone.

The risk of collusion

Even in the absence of outright collusion, there is a risk the new rules could still raise prices.

If a gentailer discounts the supply price it charges its own retail arm, it must then offer that same rate to its competitors.

Gentailers may conclude it is better to withhold discounts entirely. Since the proposed rule means they all face the same incentive, a de facto consensus to keep wholesale prices high could result – without them ever having to coordinate directly.

Rather than fostering competition, the rule creates an anti-competitive focal point. It may improve the relative position of independent retailers, but at the cost of worse outcomes overall – for consumers in particular.

This should not be surprising. Similar distortions have been observed in other sectors, often resulting from “best-price guarantees^[2]” or “most-favoured-nation clauses^[3]”. In these cases, firms pledge to match or beat rivals’ lower prices, or not to offer better deals to any single customer.

Likewise, “reference pricing” rules that cap United States’ pharmaceutical prices at levels set in other countries have been shown^[4] to raise prices overseas rather than significantly drop prices in the US.

Though seemingly good for consumers, these commitments can suppress price competition by deterring firms from undercutting each other altogether.

A questionable compromise

My research^[5] has explored competition in electricity markets where gentailers compete with standalone retailers.

I found integration between generation and retailing – the gentailer model – tends to deliver the best outcomes for consumers in a wide range of settings. Other studies^[6] examining electricity systems internationally have reached similar conclusions.

But consumers tend to fare worst in systems where vertical integration is prohibited. Ironically, independent retailers can also fare worse under such arrangements. This is because, despite often calling for the break up of gentailers, the vertical separation triggers higher wholesale prices.

The authority’s proposal represents a kind of middle ground: retaining vertical integration while using regulation to force gentailers to behave as if they were separated entities.

In modelling a scenario akin to this – what economists call “legal unbundling^[7]” – I found it indeed increased independent retailers’ profits. This may explain why some support such rules.

But legal unbundling also reduces other firms’ profits and, more worryingly, harms consumers by reducing supply volumes and raising retail prices.

Levelling the playing field in electricity retailing may sound like a good idea. But not, it seems, for consumers.

References

1. ^{^} authority announced plans (www.ea.govt.nz)
2. ^{^} best-price guarantees (onlinelibrary.wiley.com)
3. ^{^} most-favoured-nation clauses (onlinelibrary.wiley.com)
4. ^{^} have been shown (www.tse-fr.eu)
5. ^{^} research (www.cognitus.co.nz)
6. ^{^} Other studies (www.cognitus.co.nz)
7. ^{^} legal unbundling (papers.ssrn.com)