Liberalizing Electricity Markets – Best Practices

While liberalizing electricity markets is a worthy goal, it can only be achieved by adhering to best practices. Lowering barriers to entry, maintaining liquidity in consumer markets, and protecting consumers are vital steps. It is also essential to support markets for intermediaries, adapt regulations to innovations, and ensure that costs are transferred effectively.

Reducing Barriers to Entry

Barriers to entry can often be reduced by “white label” arrangements. A white label electricity retailer does not generate the electricity itself, but instead buys from producers and sells to consumers. Since the white label retailer does not actually produce the power, it does not have to deal directly with complex environmental and land use regulations.

Furthermore, white label retailers can even reduce prices for consumers when dealing with producers enjoying scale economies. Unlike consumers, a white label retailer is usually large enough to exercise some market power, negotiate lower prices, and reduce the dead-weight loss from limited competition among producers.

Creating a Liquid Consumer Market

New retailers in the electricity market can only succeed when switching providers is a smooth process for consumers. Consumers may also suffer from a lack of information and status quo bias, particularly in markets that have been monopolized for an extended period. Research by Nobel Prize-winning economist Richard Thaler indicates that status quo bias is much more significant than previously thought. Even when they are aware of new options, consumers must overcome fear, uncertainty, and doubt before making changes.

The unknown reliability of new firms and possible disruptions of service during a transition can hold back consumers from switching electricity providers. Finally, consumers are highly sensitive to fixed costs. The need to install new equipment, such as meters, can delay savings from switching and deter changes.

Consumer Protections are Vital

Consumer protection has two principal objectives in a liberalized electricity market. The first is ensuring that as many consumers as possible have access to choose. High exit fees and overly large discounts for long contracts can contribute to vendor lock-in and eliminate the liquid consumer markets that are necessary for competition to flourish.

It is also essential to protect vulnerable consumers. Merely opening the market to competition does not ensure that competition will come to all corners of the market. In electricity markets, rural areas are frequently much less competitive. Low-income consumers and others who use less electricity may also face high minimum fees without proper protections.

Healthy Intermediaries

While disintermediation is often seen as a path to lower prices, healthy intermediaries are essential in competitive electricity markets. White label electricity retailers, community energy providers, and peer-to-peer electricity all contribute to more efficient markets.

An excellent example of the value of intermediaries can be found in the U.S. data services market, which is very similar to electricity in some respects. There are generally no intermediaries for cable Internet services, and minimum monthly fees tend to be $50 per month or more. That shuts out consumers with limited incomes and low data usage. Major wireless carriers often charge similarly high minimum fees. However, mobile virtual network operators (MVNOs) profitably resell wireless service for under $10 per month by offering plans with low data limits.

An Effective Cost Transfer Mechanism

Retail consumers typically pay slightly different prices to retailers than retailers pay on the wholesale market, which can cause markets to disconnect. The core issue is that consumers often pay a flat fee per kilowatt-hour each month, while the fees paid by retailers vary dynamically based on supply and demand. Short-term price fluctuations, such as those that occur at peak hours, cannot be passed on within this system.

Smart meters for consumers, which record the time of day that electricity is used, can help to connect prices. In the long-term, regulations that can adapt to changing technologies are critical to reducing costs. For example, smart grids allow individuals with solar panels to sell surplus electricity to others. However, that cannot happen if regulations intended for large power plants are applied to individual households.