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Unbundling Vertically Integrated Energy Companies: Benefits to Consumers

Introduction

The European Union (EU) has passed regulations that aim at governing the region’s energy sector effectively. The main aim of the legislation is to have separate producers and suppliers from the transmission networks. The unbundling regulations require energy companies to concentrate on production only, leaving out ownership of transmission grids to other players. One of the major benefits of this regulation is the availability of alternatives to consumers to select their suppliers in terms of prices. This paper seeks to discuss the benefits that will accrue to the consumers as a result of the unbundling regulation.

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Why unbundling vertically integrated energy companies is in the interest of consumers

Cost-reflective prices

End consumers will enjoy the relative cost-reflective prices that bundling is likely to bring about. According to a publication by Ernst and Young, several regressions involve the industrial gas prices within a number of countries aligned with severable variables. An example of the variables involved in the separate transmission operator. This is of significant effect in terms of its correlation with lower prices. Unbundling effect has lowered gas prices by up to 15%.

A different study ascertains the fact that increased unbundling results in lower prices of electricity. It is important to point out that this study was mainly covered in the EU region where ownership unbundling is commonly applied in the member countries. Nevertheless, this is not applicable when it comes to gas. This is because private ownership leads to higher prices, unlike the case with unbundling. The possible answer for this could be the fact that privatization eventually ends up masking the unbundling effect.

Regulation Ease and Effectiveness

Unbundling helps in the improvement of cost together with a variety of other transparency in both networks, as well as competitive businesses. Energy producers who double up as suppliers engage in a complex business of ensuring that they achieve their objectives on both fronts. However, this is challenging for the firms given the extent of operations that they involve themselves in. With the unbundling regulations in place, nevertheless, the companies specialize in one area where it becomes easy for them to be effective in their operations. Increased effectiveness translates into controlled operation costs, thus maximizing profit.

The benefits accrued by the firms as a result of profit maximization will be passed over to the end consumers of the product in terms of proper regulation and effectiveness. It will include highly competitive pricing as the firms compete with each other for the market.

According to EUR-Lex, it is difficult to achieve regulation where there lacks proper tasks division between the energy companies and the network. Companies find it difficult to control internal transactions in the same group, thereby leaving out some freedom in terms of allocation of operational costs. This may end up affecting network tariffs. The unbundling regulations require the company owning the transmission network to lose out on the likelihood of strategically relocating the internal costs. A vertically integrated firm will find it convenient to shift the related costs of performing commercial functions to the network company, as well as shift the network company’s resources to the groups’ commercial part. Thus, unbundling provides the regulator with proper insight as far as management of the network costs is concerned. Proper insight in regulation, on the other hand, extends its benefits to the consumers as they are likely to reap from the highly efficient operation of the players.

Capital/Investment Cost

The overall cost of investment and capital-output for the industry players is reduced significantly as a result of the unbundling regulation. With the increased ease with which supplier companies can integrate with energy generators and the retail, it would be equally easier for the transmission business to gain access to relatively cheaper capital. It is prudent to point out that a highly efficient capital market is likely to achieve greater efficiency in terms of cost of capital as a result of separation.

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As the cost of capital declines, the energy companies will not need to raise the prices higher in order to break even. This is different from a scenario where a bundled energy company would require paying higher rates of interest and passing the costs over to its customers through overpricing the commodity or service being offered.

Market Competition

Unbundling of the networks of distribution results in improved market competition within the commercial segments and increases welfare. A network company that is integrated enjoys both incentives, as well as a greater possibility of affecting competition within the competitive segment. This is done through distorting actions or through cross-subsidies. However, the unbundling impact results in improved network performance. The regulation also ensures that access to a non-discriminative third party is insured.

Such a scenario is likely to attract new entrants into the market, much to the advantage of the consumers. With new players entering the market, consumers will benefit from lowering switching costs, particularly if the market is on a growth path. Other related costs that consumers face in the market are also likely to be lower as a result of the ease of market entry.

Legal Tools Employed by the EU

Ownership unbundling

This is a type of ownership structure where the network functions are totally separated from other activities of the firm, including asset ownership.

Advantages

Ownership bundling has the potential of enhancing welfare. The ownership structure allows competitors together with network firms to enjoy various benefits in their specific fields of play. One of the major benefits of this effect is the elimination of barriers to market entry for interested industry players. The competition results from the fact that competitors no longer enjoy the incentive of discriminating between the various market participants. The traditional practice has been one where ‘passive’ discrimination exists between the incumbent industry players and third parties. Part of the consequences of this is the creation of an enabling environment for both existing suppliers and new market entrants to gain better access to transmission capacity that is unused from the network firm seeking to maximize profits. Concerns by competitors that their confidential information could be given to the supply arm by the vertically integrated company have been eliminated altogether.

Ownership unbundling also provides network operators with the benefit of focusing on optimisation of the main business. The regulation of the network business allows a network operator the opportunity to generate additional revenues through the expansion of the network. Incentives can be offered for ownership unbundling to pave room for investments within the network infrastructure. The network operator will also avoid a burdensome regulatory oversight, as well as a superfluous heavy unbundling programme of compliance.

Disadvantages

Ownership unbundling has the potential of lowering overall investment within the energy sector. This will culminate in high prices and endangered supply security. This will particularly be as a result of lowered economies of scale, creation of large costs of the one-off transaction, increased capital cost for the supply business, and a weakened position of the European suppliers during negotiations with suppliers from the external world.

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Ownership unbundling poses a threat in terms of diminishing the already existing investments by the vertically integrated players in the industry. There are also similar concerns to the effect that ownership unbundling will lead to much weaker independent supply firms in regard to their bargaining position compared to that of the external supplier.

Independent System Operator Model

This system is also referred to as ISO. It allows the supply company to own the physical distribution network. However, the supplier company must leave the entire operation of the network to an independent third-party company. The system does not allow vertically integrated companies to provide services to independent transmission operators.

Advantages

ISO eliminates regulatory profit, allowing the consumers to pay less in prices. The assumption in this advantage is that there are no chances of unexpected revenue shock or cost. It is also assumed that the regulatory body will allow the energy company to return on its investment that could be passed to the shareholders. In case such allowances are to be made, the regulator will require to lower regulated revenues and affect prices.

ISO’s that will not be in a position to make profits will be exempted from various perverse incentives that other profit-making ISO’s are vulnerable to. Examples include lacking the financial incentive to discriminate between different retailers. ISO’s that are in a position of making profits might benefit from such incentives where its independence was in a way compromised.

ISO’s enjoy the benefit of serving customers’ interests directly. If the company’s shareholders also turn out to be the consumers, they can incentivize the firm’s management in ensuring that the company’s actions directly serve their interests. The interests could be similar to those wished by the final customers.

The introduction of competitive prices and more industry knowledge will result from the ISO practice. Competition and industry knowledge will be achieved through new management practices, as well as better communication with players in the other industry.

Disadvantages

With the limited profit, it is highly unlikely that the ISOs could think of forming mergers in the market. Each appointed energy company will have an ISO that will most likely be optimal for the market. This will make it difficult for the companies to think of forming mergers in order to better the service.

ISO’s also offers an opportunity for shareholders from varied backgrounds to own the company. Where such shareholders are incumbent monopolists in different regions, there would be limited chances for them to manipulate or control it in a way that would exclude upstream or downstream entry. There is the likelihood of firms operating in the industry owning the ISO and behaving in the same way. This could eventually create a barricade to market entry for new players.

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Conclusion

The European Union revised its regulatory structures governing the energy sector in the region by introducing unbundling requirements. Under the new laws, energy players are required to separate their transmission interests from production and supply. Companies will focus more of their attention on single business interests, thus resulting in increased performance efficiency. Wastage will be minimized due to increased efficiency. This will likely be passed down to the consumers in form of reduced prices. Unbundling will also result in increased competition between the players. This will see the companies use the aspect of pricing as a perfect tool for sustaining market competition.

References

Baarsma, B et al. ‘Divide and rule. The economic and legal implications of the proposed ownership unbundling of distribution and supply companies in the Dutch electricity sector’, Energy Policy, vol. 35, 2007, pp.1785-1794

Ernst and Young, Final report research project: The case for liberalisation, 2006. Web.

EUR-Lex, Access to European Union law, n.d. Web.

European Commission: Energy, Single market for gas & electricity, n.d. Web.

Goldberg, S, Chapter 1 ‘Introduction and comment’ in Bram, D, H Michael & T Kim (eds.), EU energy law and policy issues (volume 3), Belgium: Intersentia Uitgevers N.V., 2012.

John, P, Incentivising Independent System Operators (ISOs), n.d. Web.

Lowe, P, I Pucinskaite, W Webster & P Lindberg, ‘Effective unbundling of energy transmission networks: lessons from the Energy Sector Inquiry’, Competition Policy Newsletter, no. 1, 2007, pp. 23-34

Zafirova, Z, ‘Unbundling the network: The case for ownership unbundling?’ 2007, International Energy Law & Taxation Review, 29

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StudyCorgi. "Unbundling Vertically Integrated Energy Companies: Benefits to Consumers." May 13, 2022. https://studycorgi.com/unbundling-vertically-integrated-energy-companies-benefits-to-consumers/.

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StudyCorgi. 2022. "Unbundling Vertically Integrated Energy Companies: Benefits to Consumers." May 13, 2022. https://studycorgi.com/unbundling-vertically-integrated-energy-companies-benefits-to-consumers/.

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StudyCorgi. (2022) 'Unbundling Vertically Integrated Energy Companies: Benefits to Consumers'. 13 May.

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