Natural monopoly and the electricity sector
My latest article at the Recon Hub, which I’ll repost in full here:
The electricity sector in my home country of South Africa is utterly dominated by the state monopoly (Eskom). Plagued by power outages, management scandals and looming price hikes, there has been much talk in recent years about liberalizing the local market. This is a movement that I strongly support and perhaps I’ll have more to say about it in the future. For the moment though, I’d like to take a step back and ask why we have monopoly power in the electricity sector in the first place, and whether there are limits to liberalization? Experts like Einar and Linda are far more qualified to talk about this topic than me, but let’s have a crack at it…
A good place to start is Steven Stoft, who opens his authoritative book on electricity market design with this pithy observation:
“In the beginning there was competition — brutal and inefficient.”
Stoft describes some of the chaos that characterised early power markets, where a multitude of companies scrapped and squabbled for consumers… only to undermine the usual benefits of competition by building redundant infrastructure on top of each other and driving up costs. Another source (Platt, 1991) describes the environment of early competition in the power sector as follows:
“The[…] experience of rate wars, distributor duplication, and torn-up streets presented an alternative that was attractive to virtually no-one.”
The key turning point — in the US at least — comes in 1898 when the newly elected president of the National Electric Light Association, Samuel Insull, convinces his fellows that the electricity business is really a natural monopoly. Electricity companies would be able to deliver their services far more effectively if they merged into a single entity. There would be no wasteful duplication of power lines and it would be far easier to raise the finances that were required for building the vast power stations to meet burgeoning demand. A mass consolidation of the industry soon followed and rest is history.
At least, it was until about two decades ago. Having leveraged the key benefits afforded by monopoly scale — grid expansion, financing of infrastructure and so on — countries began to realize that the time for (a return to) market liberalization had well and truly come. State-owned electricity companies were bloated and inefficient. Consumers were suffering under artificially high tariffs[*], while the absence of competition meant that regulators lacked the very market signals that would allow them to determine what a “fair” price was. Within short order, early adapters like the UK, New Zealand, and the Nordic countries had shown that liberalizing the power sector to forces of market competition could yield very real economic benefits. There have been many important lessons about appropriate auction design and regulation along the way, of course, but that remains a topic for another day.
However, monopoly control continues to persist in one area of every liberalised electricity market that I’m aware of… Namely, the transmission grid. The reason for this is very simple: The transmission of electricity remains — as suggested by Insull — a natural monopoly.
The theoretical characteristics that are used to define a natural monopoly in economic textbooks apply quite beautifully to electricity grids: increasing returns to scale, “lumpy” technology, etc. The upshot is that it is cheaper and easier for one large firm to provide this service than many small firms. Having multiple grid operators build separate, or even overlapping, transmission systems is simply inefficient. Indeed, countries that have experimented with competing grid operators have experienced market consolidation that ultimately tends towards a single provider. (In very large countries, you might have regional or state operators that hold sway over their designated geographic areas, such as in Australia and Canada.)
In the absence of regulation, you would thus be left with a single transmission firm that is free to charge monopoly prices to competing suppliers/consumers for access to the grid. Surely even the most ardent proponent of laissez faire would agree that it is hardly ideal to have vibrant competition among producers and consumers… only to see a middle man inflate final prices via grid monopoly power. The physical nature of electricity itself plays a reinforcing role in all of this. Electricity is a non-storable commodity and demand and supply must be kept in perfect balance at all times, which further invokes the need for some overarching regulatory body.
Grid companies thus require direct regulation and, consequently, are often legislated as independent government entities specifically mandated to operate the transmission system. Regulation of the grid operator (via rate-of-return, price-caps, etc.) is about preserving the competitive efficiencies yielded by market liberalization. And this is why it makes sense to have a regulated monopoly entity in charge of our electricity grid, even as producers and retailers should be left to compete on either side of it.
[*] This statement needs to be qualified, as tariffs in certain countries before liberalisation actually turned out to be artificially low. In this case, however, prices were typically suppressed due to subsidisation with public finances. Taxes meant that consumers paid more in the end, even if the tariffs themselves were low.
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