4.1 The Lessons of the Liberalization Period
An examination of the key learnings from the period 1990-2007 suggests
the following stylized facts about electricity markets (see Pollitt, 2008, for a fullerjustification). First, competition reduces costs (and prices) significantly. It doesthis by encouraging efficient operation and least cost and timely investment. It alsoexposes pre-existing market power. Second, consumers do respond to price signalsboth by switching and by demand reduction. There also seems little reason why allconsumers including residential consumers need centralized (and hence standardized)
protection from wholesale market price fluctuations. Consumers have exhibited significant demand for fixed tariffs, which have emerged to allow those who wish to purchase insurance against price rises to do so. Third, markets do produce significant innovation. Thus we have seen significant retail innovation in terms of energy service management for large customers, innovative products for large and small customers.
We have also seen innovation in wholesale markets in terms of approaches to risk
management and trading arrangements. Fourth, incentive regulation works and can
be very powerful in driving down costs and improving standards. However incentive
regulation should ensure that consumers benefit in a timely way from some of
the improvements. Fifth, the vertical economies of joint operation between networks
and competitive segments of the industry are not sufficient to outweigh the increased
competitive pressure that comes from clear separation of the monopoly networks
from the rest of the supply chain. This has been proved in electricity transmission, gas
transmission and may be in process of being proved for gas distribution in the UK.
Sixth, markets have proved adept at managing the short term risks associated with
power markets, though there have been issues with the lack of liquidity in the market
for long term contracts for power. The lack of liquidity in these markets may not be
serious for residential consumers, who may not want long term contracts, but they
are more significant for small supply companies who want to source power via long
term contracts rather than make their own generation investments. Financial markets
have also provided significant amounts of financing for power investments, much of
it at low rates of interest. Finally, markets have been good at choosing between technologies
on the basis of price, as for example demonstrated by the move to CCGT in
the 1990s and the decline and renaissance of nuclear power investment in response to
market prices. Although R+D expenditure has collapsed as a result of deregulation, a
significant part of this reflected inefficiency in the expenditure before reform (Jamasb
and Pollitt, 2008). Equally, it has proved possible to correct for any reduction in R+D
budgets by incentivizing private R+D expenditure decisions via the introduction of
decentralized innovation funding incentives (see Pollitt and Bialek, 2007).
An examination of the key learnings from the period 1990-2007 suggeststhe following stylized facts about electricity markets (see Pollitt, 2008, for a fullerjustification). First, competition reduces costs (and prices) significantly. It doesthis by encouraging efficient operation and least cost and timely investment. It alsoexposes pre-existing market power. Second, consumers do respond to price signalsboth by switching and by demand reduction. There also seems little reason why allconsumers including residential consumers need centralized (and hence standardized)
protection from wholesale market price fluctuations. Consumers have exhibited significant demand for fixed tariffs, which have emerged to allow those who wish to purchase insurance against price rises to do so. Third, markets do produce significant innovation. Thus we have seen significant retail innovation in terms of energy service management for large customers, innovative products for large and small customers.
We have also seen innovation in wholesale markets in terms of approaches to risk
management and trading arrangements. Fourth, incentive regulation works and can
be very powerful in driving down costs and improving standards. However incentive
regulation should ensure that consumers benefit in a timely way from some of
the improvements. Fifth, the vertical economies of joint operation between networks
and competitive segments of the industry are not sufficient to outweigh the increased
competitive pressure that comes from clear separation of the monopoly networks
from the rest of the supply chain. This has been proved in electricity transmission, gas
transmission and may be in process of being proved for gas distribution in the UK.
Sixth, markets have proved adept at managing the short term risks associated with
power markets, though there have been issues with the lack of liquidity in the market
for long term contracts for power. The lack of liquidity in these markets may not be
serious for residential consumers, who may not want long term contracts, but they
are more significant for small supply companies who want to source power via long
term contracts rather than make their own generation investments. Financial markets
have also provided significant amounts of financing for power investments, much of
it at low rates of interest. Finally, markets have been good at choosing between technologies
on the basis of price, as for example demonstrated by the move to CCGT in
the 1990s and the decline and renaissance of nuclear power investment in response to
market prices. Although R+D expenditure has collapsed as a result of deregulation, a
significant part of this reflected inefficiency in the expenditure before reform (Jamasb
and Pollitt, 2008). Equally, it has proved possible to correct for any reduction in R+D
budgets by incentivizing private R+D expenditure decisions via the introduction of
decentralized innovation funding incentives (see Pollitt and Bialek, 2007).
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