Working Paper No.49 – Differential Prices
AGL Applied Economic and Policy Research
Reforming reform: differential pricing and
price dispersion in retail electricity markets
Paul Simshauser & Patrick Whish-Wilson
Level 6, 144 Edward Street
Brisbane, QLD 4001.
June 2015
Abstract
Price discrimination is unremarkable in economics. Indeed, in industries where fixed &
sunk costs represent a significant portion of total cost, differential pricing is usually
welfare enhancing. But when monopoly industries are restructured and deregulated,
prices commence a natural drift from a regulated ‘average cost’ uniform tariff to
competitive differential prices, and this can raise problems for policymakers. Deep
discounts are welcomed. High Standing Offer tariffs are not. But theory predicts and
empirical evidence confirms regulatory efforts to cherry-pick differential prices in
asymmetric markets will damage consumer welfare. In this article, we analyse
differential prices in Victoria and Queensland and contrast these with the industry
average total cost and the marginal cost of retail supply. We find deregulated Victoria
displays high price dispersion with Standing Offer tariffs 10% above industry average
total cost and the marginal offer at break-even prices (i.e. zero profit). In the semideregulated Southeast Queensland market, there is lower dispersion but marginal offers
include a 6.7% mark-up. Efficient pricing requires the marginal unit produced to be
priced at marginal cost, and Victoria meets this criteria. However, while there are
strong reasons to expect in aggregate differential prices will have positive distributional
effects vis-à-vis vulnerable households, we identify that high Standing Offer tariffs in
Victoria has produced inter-consumer misallocations. We conclude policy initiatives
designed to help firms shift vulnerable households from Standing Offer tariffs is
necessary.
Keywords: Price Discrimination, Non-Linear Prices, Electricity Tariffs.
JEL Codes: D24, L11 and Q48.
1. Introduction
A seemingly problematic issue facing policymakers in competitive electricity markets is the
dispersion of residential tariffs that naturally follows deregulation events. To be sure, price
dispersion at the residential level represents a material change from a 120-year history of uniform
tariffs. Under regulated monopoly conditions, State Electricity Commissions gazetted a single
two-part tariff and all households faced that uniform price.
During the 1990s industry restructuring led to the creation of rival retailers and by the early2000s Full Retail Contestability was implemented. Standing Offer tariffs were declared by the
regulator, and incumbent retailers were obliged to offer this tariff and default levels of service to
all customers in their franchise. The Standing Offer was a regulated ‘price-cap’ and formed a
price-to-beat. Rival new entrant and adjacent franchise retailers would poach the incumbent’s
(former franchise) customers by offering discounts against the Standing Offer price-cap. Price
dispersion had thus become a central feature of the competitive market.

Paul Simshauser & Patrick Whish-Wilson are economists at AGL Energy Ltd. AGL is an incumbent energy retailer in Victoria with
530,000 electricity customers. Paul Simshauser is also a Professor of Economics at Griffith University. The authors are grateful for
helpful comments on an earlier draft from Gavin Dufty (St Vincent de Paul Society), Prof John Foster (The University of
Queensland), Tony Wood & David Blowers (Grattan Institute), Rajat Sood (Frontier Economics), Nicole Wallis & Lauren Solomon
(AGL Energy). All remaining errors are entirely the responsibility of the authors.
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Once retail electricity markets exhibit workable competition, the need for regulated price-caps
disappears. At this point, incumbent retailers are able to set their Standing Offer tariff to meet an
ongoing obligation to supply in former franchise areas. Changes to market structure typically
follow. Once the risk of regulatory error in determining price-caps is removed, the number of
rival retailers will increase and the array of products offered will expand exponentially to meet
variations in consumer preferences. Given common fixed & sunk costs, price dispersion will
increase, not decrease, as competition intensifies. This progression of additional entry, greater
product complexity and price dispersion is common in capital-intensive industries and
deregulated markets such as telecommunications, airlines and energy as Borenstein & Rose
(1994), Dana (1998, 1999b), Levine (2002), Baumol & Swanson (2003), Elegido (2011),
Littlechild (2014) and others explain.
Electricity is often thought of as homogeneous. One might logically deduce that uniform prices
would therefore be prevalent amongst household customers in competitive electricity markets.
However, economy airline seats between two cities, while discretionary, are also homogeneous.
Each economy seat has the same underlying cost yet the extent of price dispersion is striking. We
reviewed economy fares between Brisbane-Sydney in Q1 2015 and found the price range spanned
a 76% range. Standing Airfares could be found for $280, time-flexible discounted seats for $210,
‘time-inflexible’ seats with loyalty points for $140 and deeply discounted budget seats could be
found for as little as $65 if purchased two weeks in advance. Despite the same underlying cost of
supply, the mark-up on a $280 seat is presumably material, and negligible on a $65 seat.
Electricity market reforms commenced from 1994 but in Q1 2015 Australia’s regional electricity
markets are replete with working examples of regulated monopoly, semi-deregulated price-caps,
and deregulated markets. In regional Queensland, households face a uniform tariff supplied by a
regulated monopolist. Southeast Queensland’s market has a regulated price-cap with two
incumbent and eight rival retailers, and routine discounts1 producing a price dispersion of 8%. In
the recently deregulated markets of South Australia and New South Wales2, 12-15 rivals compete
with price dispersion of 12-15%. In Victoria, the most mature market (deregulated in 2009) there
are three incumbents, 17 rivals and price dispersion of 30% in mixed product bundles.
In any retail market with common fixed costs, differential pricing represents the usual state of
affairs, not a market oddity. But as Armstrong (2008) notes, price discrimination is often
controversial vis-à-vis its impact on consumers, rivals and total welfare. And price dispersion in
Victoria is controversial. This is not unusual. As Levine (2002) explains of airline deregulation
in the US, adverse media and political coverage of high Standing Airfares was common in the
mid-1990s3. To generalise, with price discrimination deep discounts are welcome but high
Standing Offers are not. The intuition of the non-economist is to ban the practice but
unfortunately the likely outcomes and welfare effects are not intuitive in asymmetric markets. As
Schwartz (1986) explained, price discrimination is not unambiguously harmful to economic
welfare. On the contrary, price discrimination in capital-intensive industries is frequently welfare
enhancing (Varian, 1996; Levine, 2002; Baumol & Swanson, 2003; Elegido, 2011). In
asymmetric markets with non-trivial fixed and sunk costs, banning the practice will usually
dampen competition, facilitate collusive behaviour, harm price-sensitive consumers, leave
customers overall no better-off, and can leave all customers worse-off.
Reams of special reports have focused on price-cost mark-ups in Victoria, but they focus on
Standing Offer tariffs (see Ben-David, 2013, 2015; ESC, 2013; CME, 2015). In their analysis of
We refer to ‘routine discounts’ throughout our research and define them as visible discounted products (public websites or advertised
products). Firms discount more aggressively when reacting to customer poaching by rivals. However ‘customer save’ activity is not
visible, and hence have been excluded in our analysis.
2
SA removed price controls in 2013 and NSW removed price controls in 2014.
3
Levine (2002, p.30) adds ‘notwithstanding more than 20 years of evidence and a near-unanimous chorus of scholarly approbation’
(i.e. approval) of that price dispersion.
1
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airline prices, Borenstein & Rose (1994) largely ignore Standing Airfares and benchmark
empirical results using average tariffs noting that only 10% of customers actually pay Standing
Airfare prices. In Victoria, only 11%4 of customers are reported on Standing Offer tariffs – the
rest have moved to market contracts with discounts ranging from 0-30% off Standing Offer rates.
In this article, we examine the range of products in deregulated Victoria and contrast these with
modelled estimates of industry average total cost and the marginal cost of retail supply. To
provide context around the results, we apply the same analytical approach to semi-deregulated
Southeast Queensland. Unlike Borenstein & Rose, we do analyse Standing Offer rates because
electricity is non-discretionary, and excluding their impact would be unhelpful. But focusing
exclusively on Standing Rates is similarly unhelpful because it is an incomplete analysis and risks
misguiding policymaking as Littlechild (2014) explains in some detail.
By focusing on the range of products, our analysis reveals surprising results. Standing Offer rates
in Victoria were found to be unambiguously higher than Queensland. Based on our modelling,
they are about 10% above the average total cost of supply. However, at the other end of the
supply curve, the marginal offer in Victoria is set to marginal cost with a 0% mark-up, and is 20%
below the average total cost of supply.
Queensland default tariffs are slightly below the industry average total cost of supply but
marginal offers incorporate a 6.7% profit margin. Additionally, only 22% of customers access a
‘medium-level’ (i.e. 6-14%) discount and there are no high-level discounts available. In contrast,
almost 50% of Victorian households access what we describe as ‘high-level’ discounts (i.e. 1530%).
Total welfare is maximised when the marginal good produced is sold at marginal cost. To be
clear, in the presence of common fixed & sunk costs, there is no principle in economics that says
all prices must be set uniformly to marginal cost (Varian, 1996; Levine, 2002; Baumol &
Swanson, 2003). The characteristics of the Victorian market mean that offer prices meet the
definition of efficient pricing, and, the Queensland market does not.
However, our analysis of the Victorian market revealed a drag on efficiency and an episode of
what we define as procedural unfairness arising as a result of price dispersion, and in particular,
the level of Standing Offer tariffs. When we analysed 530,000 household electricity accounts of
a Tier 1 retailer in Victoria, it revealed an ‘inter-consumer misallocation5’ problem. Specifically,
26,000 households (4.9% of total customers) were classed as ‘vulnerable’ and were allocated to a
Standing Offer tariff – a tariff now demonstrably designed for more inelastic household
customers.
In economics, there is nothing inefficient with the differential prices of infra-marginal units
spanning above average total cost given non-trivial sunk costs. Differential pricing of output in
competitive markets is very common throughout the economy. Indeed, theory predicts that in
competitive markets with fixed costs and negatively-sloped aggregate demand functions,
differential pricing will emerge in equilibrium (Baumol & Swanson, 2003). The dispersion of
prices will increase as competition intensifies, and as Marcoux (2006) and Elegido (2011)
explain, from an ethics perspective there are strong reasons to expect differential pricing will
generally produce positive distributional effects. But these statements come with the caveat that
customers are segmented cleanly and according to their elasticity of demand with, in this
4
Based on the ESC (2014) Energy Retailers Comparative performance report - Customer Service 2013_14. We note that AER (2014)
State of the energy market 2014 reports that 25% of customers are not on Market Contracts. AGL Energy’s internal data shows the
percentage of our customers remaining on the Standing Offer lies between these figures.
5
Inter-consumer misallocation is a drag on welfare and occurs when output is allocated using multiple prices and some customers are
incorrectly segmented by the firm, or consumers misinterpret the menu of prices and incorrectly segment themselves. Either way,
some highly elastic weak segment consumers inadvertently face discriminatory prices intended for strong segments. Such a
misallocation is not possible with a uniform price.
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instance, household income being the relevant variable. And evidently the market (i.e. producers,
or consumers themselves) are misallocating some households that we define as vulnerable. For
policymakers and for the energy industry, this does present a problem. But as our review of
literature reveals, an intuitive response will almost certainly do more damage than good to
consumer welfare – hence the purpose of this article.
This article is structured as follows. Section 2 provides a review of relevant literature on
differential pricing. Section 3 outlines our modelling approach. Section 4 combines our model
results with retail market data. In Section 5 we discuss policy implications. Concluding remarks
follow.
2. Review of literature
The theory of price discrimination, which can be traced back to Pigou (1920) and Robinson
(1933), describes the practice as selling a good at different prices to different consumer
segments.6 A broader definition frequently used in contemporary literature comes from Stigler
(1987) in which two or more similar goods are sold at different price ratios to their marginal cost,
and we propose to follow this definition.7 Price discrimination is made possible by the ability to
separate consumer segments characterised by an appreciable variation in demand elasticity (i.e.
willingness-to-pay). Robinson (1933) would describe this variation in total market demand as
comprising strong (i.e. low elasticity, higher price) and weak (i.e. high elasticity, lower prices)
segments, and we use this nomenclature throughout.
For price discrimination to persist, consumers must not be able to arbitrage or unravel price
differentials, and firms must have the ability to separate customer segments cleanly (Pigou,
1920). Price discrimination generally arises because better customer information becomes
available or because firms acquire additional tariff instruments (Armstrong, 2006b). Firms prefer
to segment consumers through directly observable characteristics. When this is not possible,
indirect segmentation occurs through customer self-selection by publishing price-schedules or
two-part tariffs which reveals (otherwise) unobservable characteristics (Stole, 2007). Price
discrimination comes in many forms. Pigou (1920) would define first-, second- and third-degree
price discrimination as follows:
1. First-degree price discrimination involves consumer segmentation in its perfect form – a
monopolist sells to each customer at uniquely different prices at their absolute
willingness-to-pay (i.e. the discrete points along a market demand curve). This means
there is no consumer surplus and all rents from exchange are extracted by the firm. In
practice, monopoly models of first-degree price discrimination form a theoretical
benchmark and can be thought of as the opposite extreme of perfect competition
(Armstrong, 2006a, Stole, 2007).
2. Second-degree price discrimination, also known as non-linear pricing, occurs when prices
vary with the quantity purchased. This form of pricing is frequently used by firms as an
‘automated sorting device’ to cleanly separate customers with a different willingness-topay. A simple and easily implementable form of second-degree price discrimination is
the two-part tariff (Armstrong, 2008).8 Second-degree price discrimination is the least
contentious form of differential pricing because ‘quantity discounts’ are widely accepted.
6
Although Dupuit (1844) is generally attributed with having identified the concept as the means by which to fund substantial sunk
costs.
7
See Stigler (1987) at page 210. As Stole (2007, p.2225) explains, the marginal cost calculation requires careful attention so as to
ensure all relevant shadow costs are included, particularly where costly capacity and aggregate demand uncertainty play critical roles.
8
The two-part tariff carries a theoretical benefit of reducing deadweight losses since the variable rate can be set to marginal cost with
the fixed charge used to extract quasi-rents. These conditions hold regardless of whether consumers have similar or heterogeneous
tastes, and can be used to endogenously sort customers further by incorporating declining block variable structures to extract
additional profit.
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3. Third-degree price discrimination, the most common9 form of discriminatory practice
found in markets, arises through intense market segmentation based on variations in
consumer willingness-to-pay. A common example is ‘student and pensioner discounts’.
Perhaps unsurprisingly given its label, price discrimination is typically viewed with negative
sentiment and a prejudiced lens by non-economists (Elegido, 2011). The classic case does
involve a profit maximising monopolist who segments the market and deploys discriminatory
prices to extract rent. Reinforcing this view is the economist’s juxtaposed model of perfect
competition where anonymous uniform prices are set to marginal cost in an environment where
discriminatory prices could not possibly exist because rivals compete away any quasi-rents
(Robinson, 1933).
The classic prescription to maximise efficiency in economics is to set a uniform clearing price
equal to marginal cost. Under perfectly competitive conditions, one can demonstrate that
consumer and producer welfare is maximised. But there is a long list of explicit and implicit
assumptions underpinning this classic prescription including constant returns to scale, no
common fixed or sunk costs, no transaction costs, perfect information, and perfectly elastic
demand amongst many others. When these assumptions are progressively relaxed, especially
those relating to fixed & sunk costs, perfect information and perfectly elastic demand, the basic
principle of a uniform price at marginal cost breaks down. And, it is under such conditions that
differential prices are usually welfare enhancing, and attempts to ban the practice can damage a
wide class of consumers, and provide little if any benefit to consumers in aggregate.
That price discrimination can be welfare enhancing may seem counter-intuitive. But the key to
understanding the logic underpinning such outcomes is to recall three fundamental propositions in
economics in the presence of fixed and sunk costs. First, price discrimination is not
“synonymous” with market power abuse. Market power involves withholding capacity and
reducing output to raise prices. This appears to be the only necessary condition for market power
(Klein, 1993). Price discrimination on the other hand is the primary means to overcome output
constraints as Appendix I demonstrates. Second, to maximize welfare the marginal good
produced must be priced and sold at marginal cost. But there is no principle that says all units
must be sold at that price. And third, economics does not enshrine a principle of cost-reflective
pricing per se. To produce Pareto efficient outcomes the core principle is that infra-marginal
output prices relate to consumer willingness-to-pay. Notions of accounting costs have no
relevance in terms of market efficiency. As Varian (1996, p.2) explains:
…forcing a firm to charge a [uniform] price equal to marginal cost can easily fail to be
efficient if such pricing fails to cover total cost… [But] there is nothing inherent in these
principles that says the price must be constant – nonlinear prices are very common in the
real world. Efficient pricing only requires that the marginal unit of the good must be sold
at marginal cost – not that every unit of the good be sold at marginal cost…
Energy is a non-discretionary item, and this clearly necessitates a careful approach to our
analysis. Noting its non-discretionary nature, Levine’s (2002) example of a non-discretionary
consumable good (i.e. beef) provides an elegant example that illustrates how price discrimination
can enhance consumer welfare compared to uniform pricing. Recall our definition of price
discrimination involves products with similar marginal costs being sold at different price-cost
mark-ups. The cost of processing cattle – from farm, to abattoir, to end-consumer – involves
substantial common fixed and sunk costs and transaction costs along the value-chain in order to
produce final cuts of beef. These include farming, transporting the livestock, abattoir processing,
9
Oddly enough, at the time Pigou (1920) envisaged it being the least common.
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transportation to retail outlets, the butcher’s labour, tools and equipment, and retail store
overheads. Final cuts of beef include rib fillet, sirloin, rump, chuck and mince amongst others.
Despite having near-identical short run marginal costs, each cut of beef is priced differentially
and most bear no direct resemblance to either marginal or average total cost. Specifically, there is
no obvious cost-based reason why our local butcher charges $32/kg for rib fillet, $27/kg for
sirloin, $22/kg for rump, $16/kg for chuck and $13/kg for mince. And butchers in suburban
Brisbane have no evident source of market power.
Yet these differential prices in the market for beef produce substantially more efficient outcomes
than the counterfactual where discrimination is banned. If all cuts of meat were priced uniformly,
one would expect rib fillet to be constantly sold out, and chuck steak undersold (and eventually
thrown out once freezer capacity is exhausted). Low income households would lose access to
cheap cuts because a uniform price is likely to be $20+/kg. And, total quantities sold would
reduce thereby raising the average total cost of all remaining cuts of beef, resulting in a higher
average unit price. As Borenstein (1985), Holmes (1989), Varian (1996), Dana (1999b), Levine
(2002), Baumol & Swanson (2003), Armstrong (2006a, 2008), Stole (2007), Esteves (2009) and
others note, one should not expect predictions of monopoly discrimination theory to survive
empirical tests of live data in competitive markets.
So how should energy market policymakers proceed when encountering differential pricing? The
short answer is cautiously. From a public policy perspective there are two considerations. First,
analyse the effect of introducing competition when a dominant incumbent monopolist is able to
respond using discriminatory prices. Second, analyse the effect of banning price discrimination
when differential pricing is already prevalent (i.e. forcing participants back to uniform prices).
2.1
Price discrimination: monopoly
The early literature on price discrimination focused on monopoly firms and the use of ornate
tariff structures to maximise profit. When monopoly firms deploy discriminatory prices, profit
can only increase. This stands to reason. When a monopolist has access to discriminatory prices
it solves the profit maximisation problem with fewer constraints. By combining detailed
customer information with ornate tariff structures, the firm would only chose this pricing strategy
over uniform prices if it expected to do better (Corts, 1998). As Armstrong (2006a) and Stole
(2007) observe, they will certainly do no worse.
One may then be tempted to conclude monopolists should be prohibited from price
discrimination. But the welfare impacts of third-degree price discrimination are ambiguous. In
some instances, price discrimination can damage welfare. But in a surprisingly wide-array of
conditions, total welfare is enhanced. Limits on discriminatory prices and ornate tariff structures
can amplify market power problems and associated welfare losses, not reduce them.10
Appendix I demonstrates why a capital-intensive regulated monopoly utility cannot maximise
welfare through uniform pricing (see specifically Figures A1, A2 and A3 for details).
Differential prices, ornate tariffs and better consumer information enables monopolists to finelytune tariffs and recover sunk costs in less-distortionary ways, thus improving welfare. Indeed, as
Armstrong (2006b, p.8) and Levine (2002) explain in the context of regulated monopolies,
socially optimal prices almost always exhibit price discrimination (i.e. specifically, whenever
regulated utilities must recover sunk costs by mark-ups).
The key to distinguishing between ‘good’ and ‘bad’ examples of price discrimination is to focus
on changes in aggregate market output. Schmalensee (1981), Varian (1985) and Schwartz (1990)
10
As one reviewer noted, monopoly price discrimination provides the efficiency benchmark under such conditions.
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demonstrate that, by comparison to uniform pricing, the welfare implications of price
discrimination hinge critically on the resultant impact on total industry output. Accordingly, as
an absolute general conclusion, expansion of total output is a necessary condition for price
discrimination to be welfare enhancing.11
Student and pensioner discounts provide an example of discriminatory prices which cleanly
separates consumer segments and may have the effect of expanding total market output. By
comparison to uniform pricing, this involves raising prices to households in strong segments and
lowering prices in the (weak) student and pensioner segment. As Holmes (1989) explains, when
firms set a lower price in weak consumer segments, total output will expand and if this expansion
more than offsets any output contraction in the strong (i.e. non-discounted) consumer segment,
both total revenues and total welfare increases. The clearest case of welfare enhancing
discriminatory pricing is where new markets are supplied that would otherwise not be served
under uniform pricing (Varian, 1996).12
2.2
Price discrimination: imperfectly competitive markets
Monopoly price discrimination and perfect competition are invaluable tools for understanding
markets. But as Stole (2007) explains real-world economic activity takes place between these two
extremes. Price discrimination literature spans the range of markets with associated modelling
bounded by numerous derivations of assumptions relating to the number of rivals, information,
the size of customer segments, the ease of entry, discounts and customer poaching, mixed product
bundles and other market structure characteristics (see Katz, 1984; Borenstien 1985, Holmes,
1989; Chen, 1997; Corts 1998; Dana, 1999a; Shaffer & Zhang, 2000, Taylor, 2003; Dobson &
Waterson, 2005, Armstrong 2006a; Stole, 2007; Esteves, 2009).
With monopoly, profits can only increase with price discrimination and welfare impacts are
ambiguous. However, in competitive markets the exact opposite can occur – differential prices
can fall below the uniform price because ornate tariff structures are used by firms to attack rivals
and steal market share and can produce what Corts (1998) describes as ‘all out competition’ – an
outcome not possible in monopoly. Consequently, with imperfectly competitive markets the
impact of price discrimination on both welfare and profit is ambiguous. The number of relevant
variables also expands considerably. As we will see below, of central importance is the
symmetry of market information amongst rival firms.
Holmes (1989) demonstrates in a symmetric oligopoly model where firms agree on which market
segments are strong and weak, the outcomes arising from price discrimination are similar to
monopoly, that is, the uniform price lies between the strong segment’s high price and the weak
segment’s low price. Some consumers are therefore worse-off while others are better-off.
Whether total welfare is enhanced or not is slightly more nuanced than monopoly.
Recall with monopoly the key issue is whether output contraction in the strong market is small
relative to output expansion in the weak market. With oligopolistic markets, there are additional
variables including inefficient levels of industry fixed costs arising from ‘excess entry’, too many
firms operating at sub-optimal scale, losses arising from excessive customer switching, and losses
arising from sub-optimal coordination of prices. As Stole (2007, p.2237) explains:
From a social welfare point of view, the higher price should occur in the market with the
lower market elasticity. This is also the pattern of monopoly pricing. Because each
duopolist cares about its individual firm elasticity (which is the sum of the market and
11
To be sure, it is not a sufficient condition because other industry variables (e.g. excessive switching costs or excess entry in
competitive markets) can overrun welfare gains generated by expanded output.
12
Another text-book example is where firms are unprofitable with uniform prices and profitable with price discrimination – the classic
case being the regulated electricity utility. In such cases, markets are either shut down or sub-optimally served.
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cross-price elasticities), this ordering may fail under competition and the higher price
may arise in the more elastic market. While the average monopoly price exceeds the
average duopoly price, the pattern of relative prices may be more inefficient under
duopoly than under monopoly when firms are allowed to price discriminate. While
competition is effective at controlling average prices, it is not effective at generating the
correct pattern of relative prices. This is a key source of ambiguity in the welfare
analysis…
2.2.1
Monopolistic Competition
Differential pricing frequently occurs in markets where there is considerable entry and exit,
economies of scale, little coordination amongst firms and zero long run profits (i.e. monopolistic
competition). Katz (1984), in extending an earlier analysis by Salop & Stiglitz (1977), found that
when each firm can set multiple prices, it can either enhance or damage total welfare. When
price discrimination was allowed, customers in uninformed segments pay higher prices, and
customers in informed segments pay lower prices. In other words, price discrimination produced
equilibrium prices either side of a uniform price outcome, with the range spanning competitivelevels to monopoly-like levels. With inelastic demand, this would produce distributional
inefficiencies whereas with negatively sloped demand curves total output increases. Katz (1984)
also found price discrimination in monopolistically competitive environments could produce
adverse welfare effects when industry fixed costs were raised to inefficient levels through an
excess entry result. Katz (1984) showed that a crucial determinant of the welfare implications of
price discrimination is the relative size of the informed and uninformed consumer segments.
A fundamental sorting mechanism is brand preference and is absent from monopoly price
discrimination theory. Borenstein (1985) using a Hotelling (1929) spatial model (see Appendix II
for a description of Harold Hotelling’s duopoly model) characterised by free-entry, zero long run
profits, product differentiation (brand loyalty) and third-degree price discrimination, showed that
if firms have noisy but usable information on consumer willingness-to-pay, discriminatory prices
will emerge:
Competition among heterogeneous brands and the absence of entry barriers will almost
never prevent price discrimination, even when they cause long-run profits to be driven to
zero. In fact, when a usable sorting mechanism exists, a firm could be forced to
discriminate to avoid losses when competing with other discriminating firms…
(Borenstein, 1985, p381)
In monopoly theory, a schedule of prices acts as an automated customer sorting device based on
consumer reservation prices (i.e. willingness-to-pay). Borenstein (1985) shows that when brand
preference forms part of the primary sorting mechanism, price dispersion increases. Higher price
dispersion in the presence of loyalty produces higher short run profits, but this also induces
excess entry. Profits are reduced to zero in the long run, but partly through an inefficient rise in
industry fixed costs. By implication, second-degree price discrimination (e.g. optimal two-part
tariffs) are likely to produce more efficient outcomes than product differentiated third-degree
price discrimination. Price discrimination in monopolistically competitive markets thus increases
consumer surplus in weak segments, but Borenstein (1985) finds brand loyalty adversely effects
consumer surplus in strong segments and operates as a drag on welfare.
Armstrong (2006b) observes that when entry is relatively frictionless, price discrimination will
produce a higher number of firms initially. The welfare implications of excess entry are of course
adverse (i.e. since the fixed costs of the industry become excessive). But as Armstrong (2008)
explains the proliferation of ornate tariffs over time can be expected to eventually drive more
inefficient firms out.
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Using a Hotelling model of oligopoly, Stole (1995) examines the welfare implications of
differential pricing based on two dimensions of ‘quality distortions’ – viz. horizontal and vertical
brand preference. Horizontal brand preference occurs when consumers have a strong brand
preference associated with a specific label. Vertical brand preference is a more generalised
quality preference, in which consumer preferences may be met by any number of firms provided
they produce a high-end product or label. Stole (1995) shows that as the number of competing
firms increases, quality distortions decrease which produces a productive efficiency that
dominates the inefficiencies arising from apparently excess entry, and consumer surplus is
enhanced.
It was Robinson (1933) that first discussed the importance of the curvature of demand in strong
and weak segments. If the shape of demand in the weak segment is convex and concave in the
strong segment, then price discrimination will generally result in an expansion in output.
Schmalensee (1981) would refine these concepts for monopoly. Borenstein (1985) and Holmes
(1989) explain that in competitive markets, demand elasticity has two components; (1) the
elasticity of market demand, and (2) a firm’s own cross-price elasticity of demand. The first
element reflects the elasticity of industry demand – if all firms simultaneously reduce prices, then
total industry output will expand given negatively sloped segment demand curves. The second
element is the own-price elasticity facing individual firms holding rivals prices constant – in other
words, the second element reflects customer switching activity. Holmes (1989) establishes the
conditions under which price discrimination can reduce equilibrium firm profits and shows that as
the ratio between the elasticity of market demand and cross-price elasticity contracts, welfare is
more likely to be damaged through excessive levels of customer switching.
In an empirical study of aviation markets, Borenstein & Rose (1994) examine the nuances
between price discrimination in monopoly and monopolistic competition and show that reliance
on monopoly theories will misguide policymaking. Perhaps counterintuitively, Borenstein &
Rose (1994) along with Dana (1998, 1999b) and Stole (2007) show that price dispersion
increases as competition intensifies – not the other way around:
Monopolists and carriers in asymmetric duopolies have the least price dispersion,
followed by symmetric duopolists and carriers in competitive markets… the degree of
competition within competitive markets exerts a significant effect on price dispersion as
well… These results are consistent with predictions of competitive-type price
discrimination models and reject monopoly-type discrimination as the sole or dominant
source of airline price dispersion…
This is a crucial principle. The presence of price discrimination is not, of itself, evidence of
market power, and price dispersion rises with increasing competition (Klein, 1993; Borenstein &
Rose, 1994; Dana, 1999b; Levine, 2002; Baumol & Swanson, 2003). Borenstein & Rose (1994)
also identify that customer loyalty programs further increase price dispersion through higher
prices in strong segments. They also find greater price dispersion as more advanced information
systems become available. Conversely, they also find that when a market is dominated by weak
segment consumers, price dispersion tends to contract.
2.2.2
Oligopoly
Corts (1998) would produce one of the more critical contributions to the literature on price
discrimination in imperfectly competitive markets and identified that in a differentiated-goods
oligopoly, there are conditions by which consumer welfare is unambiguously enhanced by price
discrimination, and that banning the practice would increase profits and harm consumers. Unlike
Katz (1984) and Holmes (1989), Corts (1998) would relax the assumption of symmetric demand.
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Fundamental to understanding the implications arising from Corts (1998) is that profit and
welfare outcomes are highly sensitive to whether firms agree on which consumers constitute
strong and weak segments. When the firms agree on strong and week segments, they are said to
follow a ‘best-response symmetry’ in pricing decisions. Consequently, prices in the weak market
will fall below uniform prices and rise above in the strong market, with the resulting impact on
welfare ambiguous. This result is consistent with Borenstein (1985), Thisse & Vives (1988),
Holmes (1989), Winter (1997) and many others. However, Corts (1998, p.321) demonstrated that
when firms disagree on strong and weak segments, they display a ‘best-response asymmetry’ and
under these conditions:
…price discrimination may intensify competition, giving firms more weapons with which
to wage their war. Allowing firms to set [segment]-specific prices through
discrimination breaks the cross-market profit implications of aggressive price moves that
may restrain price competition when firms are limited to uniform pricing. Thus, firms
may price more aggressively in some markets when permitted to price discriminate; if
firms differ in which markets they target for this aggressive pricing and competitive
reactions are strong, prices in all markets may fall…
The necessary condition identified for price discrimination to produce more intense competition
is that firms do not agree on strong and week segments, and that some of the many firms will
therefore have an incentive to lower the price in each market segment. When such conditions
hold, consumer welfare was demonstrated to be unambiguously improved.
Another crucial insight from Corts (1998) was if asymmetric markets are forced back to uniform
pricing due to policy intervention, firms will naturally retreat to their strong market to maximise
profit. Under asymmetric conditions with less competitive pressure, the subsequent pricing
behaviour of the firms will resemble monopoly. Katz (1984) and Thisse & Vives (1988) also
showed that in these latter circumstances uniform prices can be above all discriminatory prices
with the size of the uninformed market being a crucial determinant.
In markets characterised by best-response asymmetry many outcomes are possible – from prices
rising in both segments to prices falling in both segments. Stole (2007, p.2241) demonstrates that
in markets characterised by best-response asymmetry competition produces an increase in price
dispersion that is ‘twice as large as the price-discriminating monopolist’. This makes intuitive
sense. A price discriminating monopolist sets price to maximise profit based on market elasticity
only. With oligopoly, price dispersion reflects the combined dynamics of market elasticity and
cross-price elasticities.
Bester & Petrakis (1996) examine customer poaching given customer switching costs in a
Hotelling model with symmetric franchises and fixed demand. They show price discrimination
enables firms to compete on more fronts and customer poaching (via enticements) has the effect
of reducing customer switching costs, competition is intensified, profits are lower and consumers
are better off. Shaffer & Zhang (2000) extend the analysis to include a market comprising
asymmetric franchise areas and customer loyalty. In a market characterised by best-response
asymmetry, they show that banning price discrimination always damages some consumers, and
they derive the conditions under which all consumers are worse-off.
Matutes & Regibeau (1992) and Whinston (1990) examine variations of dual product retailers
and show that mixed product bundles (e.g. electricity & gas) result in higher discounts and
banning them harms consumers, although in certain conditions one market can be used to
foreclose small rivals in the other. Dobson & Waterson (2005) identify conditions whereby
national retailers commit to uniform prices in order to mute competition with rivals.
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Chen (1997) examines behavioural-based customer poaching in a duopoly market where
consumers face switching costs, but firms poach customers by offering enticements thus reducing
switching frictions. In a two-period model, Chen shows that in mature markets price
discrimination produces more competitive outcomes and firms are worse-off. However, the
effect on consumers is ambiguous because excessive switching impairs the efficiency of the
market. Taylor (2003) extends Chen’s (1997) analysis and concludes welfare is damaged by such
markets due to excessive time and effort spent by customers to switch suppliers in the context of
a limited commitment model (i.e. all contracts are short term). A key insight from Taylor
(2003)13 is that when three or more competitors exist, firms earn economic rent on some
customers but zero economic profit overall because they face strong incentives to price belowcost in non-franchise patches to poach rivals’ customers. Firms recoup the investment through
higher prices to those customers who turn out to be loyal.
Armstrong (2006a) demonstrates with a two-period model that when franchise firms with
customer purchase histories can price discriminate, they tend to treat ‘past customers’ as strong
segments and treat rival customers as weak segments – and price accordingly. Best response
asymmetry therefore prevails. As more information is made available to firms, Armstrong
(2006a) finds profits are destroyed in subsequent periods. Consequently, price discrimination
means that all prices are lower in the second period compared to uniform pricing (unless
consumers are naive).
Chen (2006) takes this a step further by identifying the conditions under which a dominant firm
uses discriminatory prices to induce the exit of an entrant by limit pricing to a rivals past
customers, while Vickers (2005) suggests banning discrimination provides new entrant rivals
with protection, or as “a safe haven from full rigours of competition”. Consequently, banning
price discrimination can weaken competition which harms marginal consumers and benefits more
inelastic consumers.
To summarise, the fact that firms can be worse-off using price discrimination in imperfectly
competitive markets is a fundamental difference with monopoly theory. Monopolists are always
better-off when they price-discriminate. Competitor firms are better off holding the behaviour of
rivals constant. But once this assumption is relaxed, rival firms find themselves in a classic
Prisoners Dilemma and if segment information is asymmetric, they are likely to be worse-off.
Another important result is that price dispersion in imperfectly competitive markets will be twice
that of a profit maximising monopolist. A regulatory ban of price discrimination can therefore
facilitate tacit collusion. The key is whether firms agree on strong and weak markets.
2.3
Competitive markets
Price discrimination has thus far been explained in the context of special industry conditions such
as non-trivial fixed & sunk costs, declining cost monopoly, product heterogeneity, the presence of
location costs or transaction costs, demand uncertainty with capacity constraints and so on. Any
of these conditions can explain why prices deviate from uniform prices (i.e. because market
conditions deviate from perfect competition). However, Klein (1992) observes that in sorting
through such characteristics one needs to be careful labelling them ‘imperfections’ merely
because they deviate from the model of perfect competition when in fact they are pervasive in
real world markets. As Levine (2002) and Baumol & Swanson (2003) explain, common fixed
and/or sunk costs of production are predominant, not unique conditions.
Coase (1946) noted that apart from marginal cost frequently being indeterminate, the presence of
fixed & sunk costs means that marginal cost pricing breaks down. That is, when fixed & sunk
costs represent a significant portion of total cost, firms cannot survive unless their pricing
13
Another key insight from Taylor (2003) is that a loyal base of customers in a contestable market characterised by poaching is indeed
a valuable asset of incumbent firms.
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decisions deviate from marginal cost. To be clear, in declining cost industries, uniform prices at
marginal cost must result in a bankruptcy event (see Figure A1b in Appendix I). Earlier research
explored providing ‘heavy’ sunk cost industries with taxpayer funded subsidies (Hotelling, 1938).
Coase (1946) would point to multipart pricing (viz. second-degree price discrimination) as being
the most efficient solution while Lewis (1941) explained why many competitive industries rely
on non-linear prices and other deviations without notable impairment to market efficiency.
The reality is that classical price theory offers no explanation of how fixed & sunk costs are
recovered in competitive markets. Monopolistic competition attempts to explain the short run
recovery of sunk costs by introducing concepts such as customer loyalty and product
differentiation while oligopoly and monopoly theory explain the recovery of sunk costs through
the exercise of market power and reduced output (Klein, 1993). Yet as Levine (2002, p.1 & 28)
explains, price discrimination and price dispersion equilibrium are prevalent in highly
competitive markets and occurs as the means to recover simultaneously incurred common fixed
& sunk costs in markets where no apparent market power exists:
Perhaps an even more dramatic example can be found in the fast food industry. It is a
commonplace in the business that a fast food restaurant sells hamburgers with a much
lower mark-up from variable cost than is entailed by the prices of french fries and soft
drinks (which are sold separately at very high margins above variable cost). How can
we explain this in a world without market power? …firms constrained by competition
from earning monopoly rents will adopt price discrimination as the optimum strategy to
allocate common costs among buyers. Not only is this very often welfare enhancing (as
Ramsey pricing suggests it is for certain monopolists), it is not evidence of the unilateral
or collusive power to affect industry output, which is at the heart of the “monopoly
power” or “market power” concepts…
Because fixed & sunk costs are pervasive throughout the economy, along with discriminatory
pricing, the practice cannot of itself be taken as ultimate evidence of market power. As we noted
earlier, market power consists of the ability to withhold capacity and reduce output so as to raise
price and this appears to be the only necessary condition for market power (Klein, 1993; Levine
2002; Baumol & Swanson, 2003).14 As Appendix I (see Figure A2b) demonstrates, price
discrimination is frequently the means by which to overcome output constraints.
Dana (1998) examines certain US airlines routes in the context of a market characterised by peak
demand uncertainty, non-storability, frequently underutilised capacity and intensely competitive
routes characterised by the absence of market power. He shows that firms use discounted
advance purchase tickets to reduce demand uncertainty and sub-optimal capacity holding costs,
and that consumers with a low willingness-to-pay and high certainty (e.g. holiday travellers) are
more likely to advance purchase these discounted seats which is consistent with the patterns
associated with second-degree price discrimination under conditions of monopoly.
Dana (1999a) shows it is efficient for airlines to allocate different seats at different times and at
different prices, and warns against the notion that the dispersion in prices is synonymous with
market power – viz. discriminatory pricing alone is not sufficient evidence that market power
exists.
Levine (2002) and Baumol & Swanson (2003) explain that price discrimination is frequently how
competitive firms recover their costs in a way that mirrors Ramsey15 pricing, but instead of facing
14
Klein (1993) is actually referring to an interpretation by the US Supreme Court (by Justice Easterbrook). For further details, see
Klein (1993) at pages 44 and 80.
15
Ramsey pricing was designed to be deployed in regulated monopoly industries as a means by which to recover common fixed and
sunk costs in a least distortionary way, i.e. setting a high price in the relevant strong market and low price in weak markets –
essentially combining an inverse-elasticity rule with multi-part tariffs to recover infra-marginal costs for a given regulated revenue
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a regulated revenue constraint, the broader market imposes a proximate revenue constraint on the
rival firms. That is, prevailing prices include all separable costs, and some component of
common fixed & sunk costs in a way that is inversely related to the demand elasticity of segments
served. And because the market (not a regulator) imposes the revenue constraint only efficient
firms survive. In such markets, no producer has market power and discriminatory prices emerge
under the context of repeated non-cooperative games. By implication, firms continuously adjust
cost structures and pricing schedules or exit the market.
So how does equilibrium emerge in such a market? Discriminatory pricing strategies of highly
successful firms are imitated by rivals and entrants with subsequent competition ensuring
economic profits are progressively competed away.
Firms that experience indivisibilities (i.e. common costs), sunk costs and uncertain
demand cannot operate efficiently without price discrimination. In a competitive market
all surviving firms will adopt a variant of this strategy…firms that do not price
discriminate can neither offer a wide choice nor can they minimise their capacity costs.
They will earn less revenue per unit of capacity offered. Over time, they will tend to
disappear. Because competition moves towards a set of prices that generates no rents, it
will be necessary to maximise revenues subject to the competitive constraint and
minimise costs to stay in business. Since the only way to maximise revenues and to
minimise costs is to have price segmentation based on elasticity of demand, surviving
firms will tend to do so…(Levine, 2002, p.23).
2.4
Electricity markets
Considerable economic literature exists which analyses the welfare implications of second-degree
price discrimination in regulated electricity markets dating at least as far back as Lewis (1941).
Hausman & Neufeld (1989) provide a good summary of historical developments while more
recent research such as Kopsakangas-Savolainen (2004) contrasts the welfare implications of
different pricing forms (viz. marginal cost, average cost, optimal two-part tariff, Ramsey pricing).
Analysis of third-degree discriminatory pricing in competitive (i.e. restructured) electricity
markets by academic economists primarily originates in Great Britain and notably from 2009
onwards (see Davies et al. 2009; Hviid & Waddams Price, 2012; Waddams Price & Zhu, 2013;
Flores & Waddams Price, 2013; Pollitt & Haney, 2014; Littlechild, 2014). The reason for this is
that Britain’s energy regulator, Ofgem, produced ‘working laboratory conditions’ by imposing
discriminatory bans on rival energy retailer product suites from 2008. Ofgem formed a view that
Standing Offer tariffs in the British energy market were unfair and risked adversely affecting
vulnerable households faced with paying those tariffs. This is similar to concerns raised by some
Australian authors (i.e. Ben-David, 2013, 2015; ESC, 2013; Dufty & Johnson, 2014; CME, 2015
and others).
Ofgem was reacting to differential prices amongst household segments and noted that differences
could not be explained by their estimates of variations in cost. Ofgem also observed the so-called
‘Big 6’ incumbent retailers offered deep discounts in rival areas while maintaining higher
Standing Offer tariffs in their own franchise area – the standard two-period customer poaching
environment under best-response asymmetry modelled by Armstrong (2006a).
Rather than interpreting the relevant implications of Armstrong (2006a) and design a targeted
response, Ofgem pursued a strategy of trying to eliminate differential prices and discounts
between franchise and non-franchise areas by regulatory policy, enforcing retail licence
constraint. Ramsey pricing has long been regarded as a benign form of discriminatory pricing and preferable to uniform prices in
declining cost monopoly industries. See Ramsey (1927).
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conditions of common mark-ups across regions to halt discriminatory mixed bundling and
behavioural-based customer poaching in an ostensibly asymmetric Corts (1998) market.
As Hviid & Waddams Price (2012) explain, Ofgem attacked discriminatory practices because the
regulator perceived the rising variation in products and pricing to reflect an inherently noncompetitive environment. In other words, rather than associating rising price dispersion with
gradually intensifying competition (as in Borenstein & Rose, 1994; Dana, 1998, 1999a, 1999b;
Armstrong, 2006b; Stole, 2007) Ofgem interpreted the price spread as evidence of market power
– an interpretation Klein (1993), Baumol & Swanson (2003), Levine (2002, p.4) and others warn
against:
…there is still a general assumption that the existence of price discrimination implies the
existence of market power. In the hands of those who make economic policy, this
formulation is dangerous. Price discrimination is often unpopular, at least among those
paying the higher of the discriminatory prices… Thus political pressure generated by
resentment of price discrimination is usually expressed as calls for measures that
eliminate the market power assumed to underlie it. And given that perfect regulation is
as rare as perfect markets, those measures can easily produce results inferior to those
they were intended to remedy. This imperfect regulation is a particular problem when
the market power does not exist…
Littlechild (2014, p.9) explains there is no economic basis for assuming competition in electricity
markets will produce equal mark-ups on products:
[Equal mark-ups] may correspond to some concept of fairness or bureaucratic or
political convenience but they bear no correspondence to commercial reality… contrary
to Ofgem’s assumption, differential pricing is not a sign that the retail energy market is
not effectively competitive – on the contrary, it is consistent with that market being very
competitive indeed…
We know from Corts (1998) that regulatory policy designed to stamp-out discriminatory practices
in best-response asymmetry markets will constrain competitive outcomes, not enhance them.
After all, discriminatory prices and ornate tariffs are used by firms to attack rivals and when they
are banned, it is difficult to imagine how competition might then intensify. Drawing from Katz
(1984), Thisse & Vives (1988) and Corts (1998), theory predicts that firms will retreat to strong
markets when discriminatory practices are banned.
Unfortunately for the British consumer, the empirical evidence confirms that limiting
discriminatory practices reversed the intensity of competition. Firms did retreat to their strong
markets, energy retailers removed competitive tariffs, competition was muted, available discounts
continued to contract, customer poaching slowed, switching rates fell as gains from switching
diminished (switching costs remained constant), overall tariff mark-ups then began to increase,
and ultimately energy retailer profits increased materially (Hviid & Waddams Price, 2012; Flores
& Waddams Price, 2013; Pollitt & Haney, 2014; Littlechild, 2014).
The regulatory policy designed to limit high Standing Offer prices was, by any measure, an abject
failure. Discriminatory bans had the exact opposite effect to that (presumably) intended. But
rather than acknowledge the problems arising from its interventions, Ofgem would conclude a
market failure existed and that ‘more radical action’ was required (Littlechild, 2014). The
regulator formed a view that the market had become too complex, with a proliferation of tariffs
and products, and this was why customer switching rates had plunged.
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Again however, theory and empirical research predicts a proliferation in the number and the
complexity of products is consistent with intensifying competition, not the opposite. New
products are how firms attract and ‘poach’ a rival’s idle customer segments. It is not evidence of
a market failure (Klein, 1993; Borenstein & Rose, 1994; Dana 1999a, 1999b; Levine, 2002;
Baumol & Swanson, 2003; Littlechild, 2014).
Ofgem considered regulating electricity fixed charges although fortunately for the British energy
consumer this was abandoned.16 Instead a rule was enforced which limited energy retailers to no
more than four tariffs per fuel and payment method, and specified a simple (flat rate) two-part
tariff as the only permissible structure (i.e. inclining/declining block structures were prohibited)
in an attempt to simplify products. Far from improving matters, the market deteriorated further,
and again, in predictable ways consistent with theory as Littlechild (2014, p.24) explains:
…these tariff restrictions came into effect on 1 January 2014. There were predictable
consequences. Suppliers naturally chose to keep their most popular and profitable tariff
types and phase out their minority preference tariffs… Supplier E.On previously had a
StayWarm tariff that offered customers over 60 years of age a fixed monthly bill
regardless of how much energy the customer used. This tariff was popular with
customers and was highlighted by Ofgem in 2001 as one of a small number of major
initiatives by companies to address the needs of the fuel poor. This tariff has now been
withdrawn… Supplier SSE earlier introduced a new tariff that, for several months, price
comparison websites deemed the best offer in the market. That tariff was prohibited
because the discount was greater in the first year than in the second… Prompt payment
discounts are now prohibited too… A supplier can only introduce a new product if it
withdraws one of its four allowed tariffs – this will surely discourage innovation…
Ofgem’s attempt to deliver on such an objective may well have reduced product ambiguity, but at
a striking cost to households. Littlechild (2014) reports consumer bills increased by over £1
billion in aggregate, with less competition and energy retailers extracted the additional profit.
Interestingly, when the ‘product simplicity’ concept was tested with British energy consumers, a
2014 survey17 revealed results that differed from Ofgem’s devised objective. 84% of customers
supported Ofgem’s pursuit of simplified tariffs and only 2% were opposed (presumably
economists!). However, when households were asked if they would support simpler tariffs if it
meant higher prices, support dropped from 84% to 26%. Further, only 51% wanted the number
of tariffs limited and only 19% wanted to stop discounts being expressed in percentage terms (cf.
pounds). Data from the Australian (see IPART, 2013) and British (see Flores & Waddams Price,
2013) electricity markets shows that the strongest driver of customer activity is the size of
anticipated gains from switching – not the simplicity of offers available. Consequently, as
Littlechild (2014) explains, by limiting discriminatory practices such as differentially low tariffs
to out-of-area rival franchises, a regulator limits the attractiveness of switching and in turn all but
facilitates near-monopoly pricing in an otherwise intensively competitive market.
British Professors Yarrow, Vickers, Green, Littlechild, and Waddams Price, all of whom have
highly regarded international reputations as independent academic economists, warned from the
outset that Ofgem’s interference would result in low-income customers being considerably
worse-off (i.e. as discounted products evaporated), competition would decline, strategic
behaviour encouraged, and energy retailers would make higher profits with no clear benefit to
consumers in aggregate.18 How did a well-resourced regulator like Ofgem allow its own
16
Clearly under such rigid pricing, the product preference of consumers cannot be met. For example, high consuming households (i.e.
households in financial hardship) prefer very high fixed charges in exchange for lower variable rates. Such preferences would be
excluded if a regulator selected anything other than a high fixed charge.
17
Research conducted by YouGov-Cambridge in January 2014. See Littlechild (2014) at page 27.
18
See Littlechild (2014 pp 12-14).
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regulatory policy to deviate so far from well-established theoretical and empirical economics?
Littlechild (2014, p.48) observed that:
…with [an] absence of economists at the highest level, is it unsurprising that Ofgem’s
retail analysis and policy has been at best economically uninformed and implausible, and
at worst been driven through against all expert economic advice? …Ofgem explicitly
rejected the advice of expert economists. Since then Ofgem has simply ignored economic
considerations and invented its own quack doctor remedies for the competition problems
it perceives…
In 2014 Ofgem handed the problem over to Britain’s ACCC equivalent, the CMA. The CMA’s
(2015) provisional findings concluded Ofgem’s regulatory strategy was misguided, had an
adverse effect on competition, and damaged consumer welfare (see CMA, 2015, para’s 140 and
144).
3. Models
In order to make sense of retail offer prices in Victoria, it is necessary to produce suitable
benchmarks of industry average total cost and the marginal cost relevant to an energy retailer.
The former can be thought of as the underlying cost structure of a vertical merchant energy
retailer while the latter can be thought of as the relevant set-point which maximises welfare, i.e.
the sum of consumer and producer surplus given regulated network charges. Applying an
identical analysis to the Southeast Queensland market helps to provide context. Our Energy
Retail Model has been documented extensively in Simshauser, Tian and Whish-Wilson (2015)
and so we propose not to reproduce the model logic here. Suffice to say it compiles all relevant
costs and produces a two-part tariff. All relevant input assumptions are listed in Appendix III
(see Table A1). The exception to this is the cost of wholesale supply. To produce these we have
used our NEMESYS Model.
The NEMESYS Model formally integrates the Levelised Cost and Power System Models
contained in Simshauser (2014a). The logic of NEMESYS is set out below, with its purpose
being to produce estimates of power plant marginal running costs and fixed operating & sunk
capital costs, the combination of which can be thought of as generalised estimates of power
system average generation costs under highly optimised conditions.
All costs and prices in the model are increased annually by a forecast general inflation rate 𝜋 in
period (year) z as follows:
𝐶𝑃𝐼 𝑧
𝜋𝑧 = [1 + 100]
(1)
Energy output from each power plant k is a key variable in driving unit fuel costs, variable
Operations & Maintenance costs and the generalised average cost estimates. Energy output is
calculated by reference to installed (perfectly divisible) capacity 𝛾𝑘 , annual capacity factor 𝜎𝑘𝑧
and run time 𝑟𝑡, which in the Model is 8,760hrs for each period z. Auxiliary losses from on-site
electrical loads are trivial and are therefore ignored.
𝜌𝑘𝑧 = 𝛾𝑘 . 𝜎𝑘𝑧 . 𝑟𝑡
(2)
To determine the marginal running costs of the kth plant in the zth period, where relevant the
thermal efficiency for each generation plant 𝜁𝑘 needs to be defined. The constant term ‘3600’19 is
divided by the thermal efficiency variable to convert the result from per cent to kJ/kWh, which is
19
The derivation of the constant term 3600 is: 1 Watt = 1 Joule per second and hence 1 Watt hour = 3600 Joules.
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then multiplied by the commodity cost of raw fuel 𝐷𝑘 . In addition to unit fuel costs, Variable
Operations & Maintenance costs 𝑣𝑘 are added. Marginal running costs in the zth period are then
calculated as follows:
𝜗𝑘𝑧 = (
(3600⁄𝜁 )
𝑘
1000
. 𝐷𝑘 + 𝑣𝑘 ) . 𝜋𝑧
(3)
Fixed Operations & Maintenance costs 𝐹𝑂𝑀𝑘𝑧 for each plant k in each period z are calculated by
the product of 𝐹𝐶𝑘 (expressed in $/MW/year) by plant capacity 𝛾𝑘 and escalated accordingly:
𝐹𝑂𝑀𝑘𝑧 = 𝐹𝐶𝑘 . 𝛾𝑘 . 𝜋𝑧
(4)
Capital costs 𝑋𝑘𝑧 for the kth plant in year z for new entrant and sunk plant are expressed as an
overnight capital cost ($/kW) which in turn is a representation of the accumulated annual capital
expenditure program 𝑊𝑘 incurred during the relevant construction period (including interest
during construction) and discounted at the relevant cost of capital 𝑊𝐴𝐶𝐶𝑘 (later defined in eq.7):
−𝑘
𝑋𝑘𝑧 = − ∑𝑁
𝑧=1 𝑊𝑘 . (1 + 𝑊𝐴𝐶𝐶𝑘 )
(5)
Ongoing capital spending for each period z is determined as the inflated annual assumed capital
works program.
𝑥𝑘𝑧 = 𝑤𝑘𝑧 . 𝜋𝑧
(6)
A pre-tax Weighted Average Cost of Capital (𝑊𝐴𝐶𝐶𝑘 ) is an essential input to the modelling and
we use the results in Simshauser (2014a) for this purpose. The general form for computing the
Levelised Cost of Electricity for each production technology can therefore be expressed as
follows:
−𝑧
𝑁
−𝑧
𝜃𝑘 = ∑𝑁
𝑧=1[(𝑋𝑘𝑧 + 𝜗𝑘𝑧 ∙ 𝜌𝑘𝑧 + 𝐹𝑂𝑀𝑘𝑧 + 𝑥𝑘𝑧 ). ((1 + 𝑊𝐴𝐶𝐶𝑘 ) )]⁄∑𝑧=1[(𝜌𝑘𝑧 ∙ 𝜋𝑧 ) ∙ (1 + 𝑊𝐴𝐶𝐶𝑘 ) ] (7)
For clarity, deducting Marginal Running Costs 𝜗𝑘 from the generalised Long Run Marginal Cost
Estimate 𝜃𝑘 defines total fixed and sunk capital costs 𝜑𝑘𝑧 , as follows:
𝜑𝑘 = 𝜃𝑘 − 𝜗𝑘
(8)
These two parameters (i.e. Marginal Running Cost 𝜗𝑘𝑧 and Fixed and Sunk Costs 𝜑𝑘𝑧 ) are key
variables in our half-hourly power system simulation model, and are used extensively to meet our
overall objective function (see eq.13).
The model dispatches the fleet of available power generating units to satisfy differential
equilibrium conditions given specified plant options available (outlined in Tables A2 and A3 in
Appendix III). In the power system model, let P be the ordered set of all hourly periods.
𝑗 ∈ {1 … |𝑃|} ∧ 𝑝𝑗 ∈ 𝑃
(9)
Demand Function
Let L be the set of all electricity consumers in the model.
𝑖 ∈ {1 … |𝐿|} ∧ 𝑙𝑖 ∈ 𝐿
(10)
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Let C𝑖 (𝑞) be the valuation that consumer segments are willing to pay for quantity q MWh of
power. We explicitly assume that demand in each period j to be independent of other demand
periods. Let 𝑞𝑖𝑗 be the metered quantity consumed by customer 𝑙𝑖 in each period pj expressed in
MWh.
Supply Function
Let Ψ be the set of existing installed power plants and available augmentation options for each
relevant scenario.
𝑘 ∈ {1 … |𝛹|} ∧ 𝜓𝑘 ∈ 𝛹
(11)
As outlined in eq.8, let 𝜑𝑘 be the fixed operating & sunk capacity costs and 𝜗𝑘 be the marginal
running cost of plant 𝜓𝑘 respectively. Let 𝑃𝑘̇ be the maximum continuous rating of power plant
𝜓𝑘 . Power plants are ordinarily subject to scheduled and forced outages. F(𝑗, 𝑘) is the
availability of plant 𝜓𝑘 in each period 𝑝𝑗 . Annual plant availability is therefore:
∑|𝑃|
𝑗=0 𝐹 (𝑗, 𝑘) ∀𝜓𝑘
(12)
However for our purposes we have set outage rates to zero and thus plant have perfect
availability. Let 𝑂𝑗𝑘 be the quantity of power produced by plant 𝜓𝑘 in period 𝑝𝑗 .
Objective Function
Optimal welfare will be reached by maximising the sum of producer and consumer surplus, given
by the integral of the aggregate demand curve less power production costs. The objective
function is therefore expressed as:
𝑙
|𝑃|
|𝐿|
|𝑃|
|𝛹|
|𝛹|
𝑖
𝑂𝑏𝑗 = ∑𝑗=1 ∑𝑖=1 ∫𝑞=0
𝐶𝑖 (𝑞)𝑑𝑞 − ∑𝑗=1 ∑𝜓=1(𝑂𝜓𝑘 ∙ 𝜗𝑘 ) − ∑𝜓=1(𝐹𝑂𝑀𝑘𝑧 + 𝑥𝑘𝑧 )
(13)
|𝐿|
|𝛹|
Subject to ∑𝑖=1 𝑞𝑖𝑗 ≤ ∑𝜓=1 𝑂𝜓𝑘 ^ 0 ≤ 𝑂𝑗𝑘 ≤ F(𝑗, 𝑘) ^ 0 ≤ 𝑂𝑗𝑘 ≤ 𝑃̇𝑘
4. Results
Our first set of results is presented in Figure 1. Note there are two ‘cost’ lines, Average Cost and
Marginal Cost. Average Cost is the industry total average cost of supply and has been derived
from our Energy Retail and NEMESYS Models. Marginal cost is also derived from our Energy
Retail model with two important changes. First, the wholesale supply cost relies on market
prices, not modelled (and highly optimised) system costs. Second, the retail profit margin has
been set to zero. Note also the diamond markers – these represent retail offers taken from
publicly available sources for the Queensland region during Q1 2015.
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Figure 1:
Queensland Average Cost, Marginal Cost and Retail Offers (4800 kWh/a)
Note in Figure 1 that Average Cost is represented by the solid line (at $1620 per annum) while
Marginal Cost is represented by the dashed line ($1325 pa). The diamond markers list out each
active retailer’s Standing Offer and their best routine discount offer. Standing Offer annual bills
are congested at $1523 pa which is exactly equal to the regulated price-cap. Furthermore, notice
that discounted offers span a tight range, from $1376-$1401. Based on our modelling, the
marginal offer incorporates a 6.7% retail mark-up (with generator economic losses 7% below the
cost of capital).
In Figure 2 we produce the same analysis for the Victorian region during Q1 2015. Once again,
Average Cost is represented by the solid line ($1366) while Marginal Cost is represented by the
dashed line (at $1049). Diamond markers represent Standing Offers and best routine discount
offers of the active retailers. There is substantial dispersion in offer prices and above all, the
marginal offer equals our estimate of the marginal cost of retail supply (with generator economic
losses 9% below the cost of capital).
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Figure 2:
Victoria Average Cost, Marginal Cost and Retail Offers (4200 kWh/a)
It is helpful to analyse customer activity in the two markets. Figures 3 and 4 present a time-series
of customers by product (i.e. standing offer, or low, medium and high discount) using data from
AGL Energy’s HANA system. Note in Queensland that there was a sharp increase in customers
securing medium-level discounts and the start of high-level discounts (just visible at the arrow)
from July 2011 to July 2012. From July 2012, there was a change in regulatory methodology to
determine the regulated price-cap. The details of this change in methodology are explained in
considerable detail in Simshauser (2014b) and so we do not reproduce such analysis here –
suffice to say the policy had the effect of limiting price discrimination and consequently, a large
number of customers lost medium-level discounts while emerging high-level discounts
disappeared.
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Figure 3:
Dispersion of customer discounts in Queensland
The Victorian market shows a continuous trend of rising discount intensity. It also shows a
continuous decline in the number of customers on Standing Offer tariffs.
Figure 4:
Dispersion of customer discounts in Victoria
Combining the information from the Figures above with public information on Standing Offer
customer numbers we have produced Figures 5 and 6 to provide a picture of market offers, albeit
acknowledging our dataset is incomplete vis-à-vis total market data. The Queensland market is
illustrated in Figure 5. The blocks represent the differential between active retailer Standing
Offers and the lowest market offer available. The height of each block represents the range of the
available products ($/pa) while the length of the blocks roughly indicates the percentage of total
customers accessing each product.
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Figure 5:
Queensland Average Cost, Marginal Cost and Tariff Dispersion
In Southeast Queensland, we estimate 46% of customers remain on the Standing Offer or base
prices with the most utilised retail product being a medium discount of about 8% (with customer
participation rates of about 22%). Routine high-level discounts ceased in July 2012. In Figure 6,
we show Victoria. Only 11%20 of customers remain on Standing Offers and in contrast to
Queensland, the most commonly accessed product by customers are high-level discounts of 1530%. The figure also highlights that these discounted products span the range through to our
estimate of the marginal cost of retail supply.
Figure 6:
Victoria Average Cost, Marginal Cost and Tariff Dispersion
5. Policy Implications
Borenstein & Rose (1994), Dana (1998, 1999a, 1999b) and Stole (2007) explain that rising
competitive intensity produces a higher dispersion of prices. Victoria is an intensely competitive
20
See in footnote 4.
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energy market with switching rates of 25-30% per annum and prices exhibit higher dispersion
than Queensland. IPART (2013) and Flores & Waddams Price (2013) show that customer
activity is driven by the expected gains available. Victoria’s differential prices have resulted in
about half the consumer base participating in the market on deeply-discounted products. Another
key observation was that the marginal offer in Victoria was equal to the marginal cost of retail
supply (and similarly for the generation segment, i.e. virtually zero profit).
From a pricing perspective, these results tend to indicate that Victoria’s market produces more
efficient outcomes than Queensland because the marginal good produced is set to the marginal
cost of retail supply. However, this conclusion comes with an important caveat. Recall from our
review of literature that with differential pricing comes the inevitability of inter-consumer
misallocation, and we explained that this is a drag on economic efficiency.
To analyse this further, we examined AGL Energy’s customer base of 3.75 million accounts with
an intention of identifying ‘vulnerable households’ on Standing Offer rates that exceeded a
counterfactual uniform average cost tariff. (Note: our definition of vulnerable households
includes all customers flagged as pensioners and concession card holders who, ceteris paribus, are
low income households with a commensurately lower willingness-to-pay). This revealed an issue
in Victoria – of the 530,000 household electricity accounts, about 26,000 or 4.9% were flagged as
both vulnerable and on a Standing Offer tariff. Assuming this result is broadly reflective of other
Tier 1 energy retailers, this does present policymakers and energy companies with an evident
‘inter-consumer misallocation’ problem.
To be clear, the semi-deregulated Southeast Queensland market has its own distinguishing
problems. The regulator materially changed its price-cap methodology in 2012 to reverse sharply
rising Standing Offer tariffs (largely network & carbon tax-related issues). The then State
Government simultaneously instituted a Standing Offer tariff freeze funded by taxpayers. Firms
interpreted the combination as a straight-forward case of dynamic inconsistency and reacted
accordingly – consumer access to deeply-discounted products ceased (with discounts initially
contracting from 15% to 5%), consumer activity slowed as gains from switching diminished, and
rival firms exited just as they were beginning to enter (Simshauser, 2014b). Ultimately, the
taxpayer-funded tariff freeze was more beneficial to strong segment households because
emerging high-level discounts available to weak segment consumers were unwound (offsetting
the benefits of the tariff freeze) in any event.21
Queensland’s aggregate market tariff schedule is however less controversial than the more
dispersed Victorian tariff schedule. Is this because price dispersion of a non-discretionary
essential service is somehow unfair? In order to answer this line of inquiry, it is necessary to
define the essential service characteristic of electricity, and the fairness principle in the context of
public policy.
5.1
Electricity: ‘an essential service’
Because electricity is a non-discretionary product, a long historical interplay between
policymakers, regulatory authorities and electricity utilities exists and overwhelmingly focuses on
how best to control prices, treading a line between protecting consumers and meeting reliability
objectives at minimum cost (see Lewis, 1941, Stigler & Friedland, 1962, Hausman & Neufeld,
1989). Olsen (2012) identifies three signal characteristics of electricity utilities; (1) asset
specificity, (2) economies of scale and scope, and (3) products that are massively consumed – and
it is the combination that matters when analysing the structure of electricity prices. Does
differential pricing collide with the provision of a non-discretionary product? After all, at its core
electricity is classed as an essential service and a human right:
21
For further details, see Simshauser (2014b). The issue here is that the $60m cost of the taxpayer subsidy could have been directed
entirely to vulnerable households.
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…consumers have largely come to view as an economic right their ability to consume
electricity whenever they wish and at whatever level of consumption they choose, and at
essentially fixed prices. Consumers view the deprivation of electricity, whether driven by
economics or lack of system reliability, as a major violation of their rights… (Hanser,
2010, p.38)
Tully (2006) explains that electricity is generally accepted as a basic need akin to water or food
and is virtually essential to contemporary human survival.22 Alexander (2010) further highlights
that inadequate electricity for heating/cooling can result in harm to health, including death.
Consequently, the individual entitlement to access electricity has long been recognised under
international human rights law.23 However, this contains a crucial definitional element – it is
formulated as a right to access, not a right to electricity per se.
A human rights approach acknowledges binding resource constraints of government and so public
policy only requires that adequate power system infrastructure exist, and, that electricity is made
available for purchase at affordable rates. To be clear, there is nothing in a human rights
orientation which suggests electricity should be provided for free (or at a loss). Energy utilities
have a duty to provide electricity on demand, but this is contingent upon consumers meeting
‘supply conditions including the ability to make financial payment’ (Tully, 2006, p.33).24 For
clarity, there is nothing in a human rights orientation which precludes disconnecting customers
under conditions of non-payment, illegal use or safety-related reasons on the proviso that such
policies are exercised consistently and follow due process.
Interestingly, Tully (2006) points to differential pricing as the means by which to enhance
fairness, through lower pricing to vulnerable customers (i.e. weak segments) with differentials
funded by mark-ups to other customer segments (i.e. strong segments). Marcoux (2006) and
Elegido (2011) similarly observe that uniform prices produce outcomes that are unfair if the
measure of fairness is consumer welfare rather than the price paid.25
Given this, neither the semi-deregulated Southeast Queensland nor deregulated Victorian markets
produce outcomes inconsistent with the essential service character of electricity. Access is
widely available and is non-discriminatory. Electricity tariffs are differentially priced in both
markets. But no consumer is discriminated against as ‘an expression of contempt’ (Elegido, 2011,
p.639). Further, hardship policies exist to protect vulnerable consumers, and disconnection
policies are uniformly applied and subject to strict regulation.
5.2
Electricity: ‘the fairness principle’
Is differential pricing of electricity somehow unfair? The notion of fairness can be interpreted in
many ways in the context of electricity tariffs. Brown & Faruqui (2014) identify three differing
viewpoints: (1) fairness requires stability of tariffs so as to avoid large bill increases to one group
of customers while simultaneously other groups benefit from large bill reductions over
compressed timeframes; (2) fairness requires that changes to tariffs should not result in large
changes in annual revenues from any particular customer class; or (3) fairness requires uniform
22
In particular, electricity cooks food, powers household appliances, supports a healthy temperature (heating or air-conditioning),
provides clean water (by powering pumps or desalination treatment), and enables proper health care (refrigerated vaccines,
operating theatres, life support systems, electro-shock therapy, emergency treatment, or intensive care). Electricity enables
agricultural production, processing and marketing (thereby ensuring food security), provides educational aids (computers, printers
and photocopiers), encourages social cohesion (participation in cultural productions, entertainment, or recreation) and generates
income earning opportunities… (Tully, 2006, p.34).
23
See Tully (2006 at page 31) for a discussion on the UN’s 1966 International Covenant on Economic, Social and Cultural Rights and
the 1979 Convention on the Elimination of All Forms of Discrimination Against Women.
24
Within this right comes certain obligations on consumers – observe contractual terms and pay promptly, permit access to read
meters and so on.
25
To be clear, neither author endorses the major premise of this argument, but the substantive point is that uniform pricing will
produce unequal degrees of consumer welfare, and if fairness is measured by welfare then discriminatory pricing becomes necessary
to achieve fairness. See Marcoux (2006) and Elegido (2011) for further details.
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tariffs be applied to a customer class. What these interpretations imply is that sudden adverse
change is unfair.
For our purposes, we follow Bunzl’s26 (2010, p.9) definition of fairness whilst ‘limiting the
problem to distributional issues of benefits (electricity) and burdens (price)’. Bunzl focuses on
the procedural concept of fairness in the same manner as the late Harvard Professor John Rawls,
who as Brown and Faruqui (2014) note, was widely regarded as the most significant philosopher
of the twentieth century. Rawls’ idealised theory of fairness is grounded in his famous phrase
from behind the veil of ignorance. This means selecting public policy for residential electricity
supply not knowing whether you are rich or poor, renter or owner, with or without solar PV
installed, and so on (Bunzl, 2010). As with various interpretations outlined by Brown & Faruqui
(2014) there is a focus on the time dimension of policy and its consequence for households. But
in our view there are two other elements relevant to any discussion of fairness vis-à-vis
residential electricity supply.
First, Olsen (2012) explains the primary purpose of regulating energy utilities is to prevent harm
that, absent those policy settings, consumers would have otherwise experienced. Thus while
economic efficiency is an important objective, public policy can hardly ignore a fairness
dimension. In other words, if differential pricing is efficient but procedurally unfair, then a
problem exists and must be resolved if the economic reforms that underpin efficient market
outcomes have any hope of durability and stability.
Second, Felder (2010) emphasizes that income is the distinguishing factor when assessing the
fairness of electricity tariff policy as distinct from any other variable. Thus, when assessing tariff
policy we should focus on how this impacts low income households. There is a positive
correlation between household income and household energy consumption. But to be perfectly
clear on this, as Felder (2010), Nelson et al (2011), Nelson et al. (2012), Simshauser & Nelson
(2014) and Simshauser & Downer (2015) demonstrate in considerable quantitative detail, large
segments of low income households also happen to be among the largest residential electricity
consumers. In other words, policy relying on such a correlation will be deeply misguided. US
economist Frank Felder (2010, p.62) demonstrates the imperfect correlation and notes electricity
prices paid by poor households are a legitimate equity concern:
Of the handful of different equity definitions and concerns, the one regarding the
regressiveness of electricity rates warrants serious consideration, especially for a
minority of low-income ratepayers that may be adversely effected…
The adverse side-effects of economic reforms in retail electricity markets have been identified by
Hogan (2010), Brand (2010), Alexander (2010) and Felder (2010) and include rate shock, an
inability of certain households to respond to more efficient price signals (i.e. due to the short run
inflexibility of household appliance stocks), transaction costs of retail market participation and
asymmetric information. Bunzl (2010) observes that being rich insulates a household from these
adverse side-effects and by implication, low income households are exposed to them.
As a general conclusion, our quantitative analysis in Section 4 indicates the Victorian market
produces more efficient outcomes and that a majority of customers were better-off vis-à-vis a
uniform regulated price. However, we also identified that 4.9% of household accounts were both
vulnerable and on Standing Offer tariffs, which is, by our definitions, evidence of inter-consumer
misallocation.
Banning price discrimination across the entire Victorian market and its 2.3 million household
consumers would produce unintended outcomes as the British industry discovered. However, if
26
Martin Bunzl is a Professor of Philosophy at Rutgers University.
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third-degree price discrimination necessarily produces inter-consumer misallocation, and those
misallocations fail our procedural definition of fairness, then our policy attention must shift to
how to remedy such outcomes. As Bunzl (2010, p.11) notes:
…The easiest cases occur when there is no change in fairness but a gain in efficiency, or
even better, a gain in both. Anything else puts the two on a collision course – something
we are often hard-pressed to take seriously because the assumptions of standard
economics with which we have been raised tell us this is impossible. For that theory tells
us that the most efficient outcome is the fairest outcome. But of course this is only true
when the idealised assumptions [of perfect competition] are satisfied…
5.3
Reforming reform
In Australia, economic reforms from the 1980-1990s rarely focused on equity considerations (or
employment growth for that matter). The objective was to remove rigidities and to maximize
economic efficiency through competition with the electricity industry being a key target. The
standard prescription for dealing with the adverse side-effects of welfare enhancing reforms is to
compensate losers. Australia’s tax and transfer system was known to be among the most targeted
in the world and this is still the case as data from OECD (2014), reproduced in Figure 7,
illustrates:
Figure 7:
OECD country distribution of social benefits (lowest & highest quintile households)
Source: OECD, 2014.
Both Federal and State Governments use Australia’s highly targeted tax and transfer system to
provide financial support to vulnerable households through concessions and rebates. However,
Tier 1 energy retailers in Australia have long accepted a shared responsibility for energy hardship
(between government, welfare groups and utilities). Banning price discrimination would not
appear to be a helpful development for weak segment consumers. But to offer the authors’
opinion, if the price dispersion of a non-discretionary good starts to injure a subset of vulnerable
customers through episodes of inter-consumer misallocation, we find it difficult to envisage
government standing idle.
But the effort of Australian policymakers, energy companies and welfare groups needs to be
targeted and measured to ensure that the key issue is dealt with, viz. how to dislodge vulnerable
households from Standing Offer tariffs if they have risen above an underlying counterfactual
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uniform average price.27 Under-reacting will fail to remedy the legitimate concerns of
policymakers and welfare groups. Over-reacting risks damaging weak segment consumers, and
benefiting strong segment consumers as occurred in Queensland in 2012.
To remedy inter-consumer misallocation, some element of ‘reform to the reforms28’ seems
necessary. As Felder (2010, p.59) observes, dealing with the notion of fairness translates to ‘a
problem of selecting the default rate that consumers are assigned’. Tier 1 energy retailers should
therefore do all things necessary to identify vulnerable customers on Standing Offer rates and
move them en-masse to a more suitable product. This sounds easy but is not. First, there is the
problem of identification. There is always some element of debate as to the ability to target lowincome families as Hogan (2010) and Borenstein (2013) explain. But as Bunzl (2010, p11),
observes:
…it is very hard to design any social policy that is not rough around the edges in
inadvertently advantaging some who should not be advantaged on grounds of equity. But
it is surely better to do that than the reverse...
Accordingly, we opted to define vulnerable households in the broadest sense. By our definition,
we capture more than 35% of AGLs consumer base for tariff-testing purposes (resulting in 4.9%
of consumer accounts being captured).
Second, there are logistical and legal constraints to moving large numbers of customers off one
product and on to another. Of these, legal constraints are most complex because they prevent
customers being moved from their assigned product and onto another without ‘Explicit Informed
Consent’ (i.e. it is illegal and firms that do so can and will be prosecuted by regulatory
authorities). This is a significant issue and requires informed debate. The requirement for such a
law is self-evident. But when we first discussed this as a potential policy of a large Tier 1 energy
retailer, it was not at all clear to us how to move 26,000 customers when marketing letter
acceptance rates are typically between 8-12%. When policymakers drafted the relevant law it
was presumably not intended to block actions by firms capable of assisting tens of thousands of
vulnerable households who are representative of an inter-consumer misallocation problem.
As with Littlechild (2015), we do not believe a regulatory requirement to enforce such outcomes
exist:
Like Ofgem, it worries – obsesses – about the level of customer engagement. This is odd:
the same people who are judged capable of making choices about occupations, lifestyles,
pensions and bringing up children, who allocate some 90pc to 97pc of their household
expenditure with no comment, are not judged capable of spending the remaining 3pc to
10pc on energy…
With policy guidance, the competitive market and rival retailers are capable of resolving such
issues (with a looming threat of regulation to follow should the author’s faith in markets be
proven wrong). As Klein (1993) observed, in competitive markets with differential prices,
product tying and customer poaching, reputational capital is a scarce and highly valuable resource
which reputable firms aim to protect. Energy retailers that have a stated objective of protecting
vulnerable customers will presumably be acknowledged by customers, the broader community
and the relevant stakeholders with their reputational capital treated accordingly. Those that do
27
The deadweight losses arising from the counterfactual pricing regime is not lost on the authors.
This is counter-intuitive since no other region in Australia’s National Electricity Market has undertaken more reform than Victoria,
but our reasoning goes to the definition of economic reform. Economic reform was originated in the 1870s and involved government
intervention and the introduction of regulation in order to protect consumers from market failures (McDermott, 2012). The first
notable economic reform was the Sherman Act (1890) in the United States and was enforced to protect consumers from monopoly
power and other strategic behavior (albeit Schwartz (1986) examines its unintended welfare-damaging consequences).
28
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not will invariably face the opposite effects. Recent media coverage of Victoria’s energy market
during FY2015 has only reinforced our view in this regard (see for example Jacks, 2015; Collier,
2014).
6. Concluding remarks
Standing Offer tariffs in Victoria have attracted rising attention over the past two years. They are
unambiguously higher than in semi-deregulated Southeast Queensland. Based on our modelling,
Standing Offer tariffs in Victoria are about 10% above the industry average total cost of supply.
Record numbers of customers in Victoria are accessing high-level discounts which span a range
through to our estimate of the marginal cost of retail supply. Amongst the various reports on
Victorian tariffs, the efficiency of marginal offers seems to receive little attention. Based on our
modelling, the marginal offer has a zero profit margin, and is 20% below the industry average
total cost of supply. Marginal offers in Victoria are unambiguously lower than in semideregulated Southeast Queensland where marginal offers incorporate a 6.7% mark-up.
Should policymakers be concerned with strong segment Standing Offer tariffs set at rates 10%
above industry average total cost while weak segment households access high-level (i.e. 15-30%)
discounts? Whether from an economics or public policy perspective, price discrimination of this
kind is known to distribute a firm’s cost recovery from strong (less-price sensitive) customer
segments to weak (more-price sensitive) customer segments, and in this sense frequently displays
positive distributional efficiency effects because the former are usually high-income households
(Elegido, 2011). However, when vulnerable consumers are misallocated to Standing Offer tariffs
designed for strong segments, a problem exists. How then should policymakers proceed?
Since the underlying cause is primarily information asymmetries, expanding customer
information communication channels and visibility of comparator websites is necessary but
unlikely to be sufficient (i.e. few Governments have done more in this area than the State of
Victoria).
One policy option is to re-introduce regulated price-caps to limit Standing Offers to some lower
level deemed acceptable. But as Section 2 explained in considerable detail, economic theory
predicts and empirical evidence demonstrates such policy damages consumer welfare in weak
segments. And in a worse-case scenario, it will damage weak segment consumer welfare and
leave consumers overall no better off. Recall the British energy regulator reacted to an equivalent
episode of differential pricing by imposing non-discriminatory clauses with the regulatory
strategy designed to reduce differentials between Standing Offers and discounted market
contracts. While successful in reducing differentials, because the market was characterised by
best-response asymmetry, it came at the expense of lower discounts and diminished product
variety, not lower Standing Offers. In the event, regulatory intervention in the British market left
a number of weak segment consumers substantially worse-off, aggregate consumer welfare was
damaged and the profits of retailers actually increased – materially. Similarly in Queensland, the
tariff determination of 2012 resulted in routine discounts contracting from 15% to 5% by the time
the decision was implemented. The key policy issue is therefore not the elimination of price
dispersion but the default tariff that customers are assigned.
Our analysis of a Tier 1 Retailer with 530,000 Victorian accounts found a non-trivial 26,000
(4.9%) households misallocated by the market. We argued that no government can afford to
stand idle if an energy market reform injures vulnerable households. Consequently, in our view
energy retailers need to analyse their respective customer base, identify the adversely affected
customers according to available customer system flags and ‘nudge’ them towards discounted
market tariffs.
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Our recommendation within AGL Energy was to shift en-masse the 26,000 customers to a 10%
discounted product. Our thinking was that, by combining the economic logic of Olsen (2012)and
Felder (2010), this level of product discount would satisfy the general criteria outlined in our
analysis of procedural fairness, viz. that vulnerable households are no worse-off from reform (cf.
a uniform tariff regime). This policy has since been formally adopted by AGL Energy and a trial
implementation is scheduled to occur from 2016.
We noted earlier that the current regulatory framework presents significant barriers to shifting a
large group of customers to a beneficial discounted product because Energy Retailers must obtain
the Explicit Informed Consent from each customer. AGL Energy’s trial attempts to circumvent
this barrier by including a provision within ‘gazetted’ Standing Offer tariffs for a 10% discount
on energy charges for Standing Offer customers eligible for State Government energy
concessions. Although a discount on Standing Offer tariffs has not been contemplated previously
in the market, we do not believe any regulatory or legislative impediments exist with this
approach. And given the outcome is an unambiguous improvement on consumer welfare, we
have sought a ‘no action’ response from the Victorian Government during the trial.
When discussing our initial findings with various stakeholders, we were occasionally asked why
the Standing Offer tariff wasn’t just reduced. To maintain the levelised cost of such an initiative,
options included (1) dropping Standing Offer rates by 1-2% for all households (i.e. including all
high income households), or (2) segment the consumer base, and provide a 10% discount to
households defined as vulnerable. The latter better meets our fairness and allocative efficiency
criteria.
We were also asked why 10%, and why only 10%? These are separate questions. When we first
raised this problem with our colleagues at welfare groups, and in particular, St Vincent de Paul
Society, we agreed that vulnerable customers should be ‘nudged’ in the right direction to prompt
market engagement rather than develop a reliance on the actions of firms. Conversely, a discount
of less than 10% would fail our own definition of procedural fairness as noted above. However,
and to be clear, customers that meet a formal definition of ‘financial hardship’ are treated
differently, preferentially, and actively managed to the most appropriate product arrangements
along with other supports.
Stakeholder groups we spoke to were generally surprised by what they described as the ‘counterintuitive result’ of banning price discrimination. They described the British experience as a
sobering lesson for policymaking. However, although understanding the efficiency of Victoria’s
marginal offers, they maintain that imputed margins in Victorian Standing Offer rates are
excessive. As economists, we interpret such a view as being a market definition issue, viz. that
Standing Offers are a separate and unique market from the balance of competitive market offers
and not exposed to competition. The Courts (in the US at least) do not separate product markets
along such lines as Klein (1993) explains in some detail. However, as part of the debate in
Victoria, it has been proposed by various stakeholders that energy retailers gazette Standing Offer
rates on the same day to add to existing competitive dynamics. This is consistent with sound
economic and public policy principles and therefore seems a helpful suggestion.
The non-discretionary nature of electricity means that energy retailers need to reorganise
vulnerable customers away from high Standing Offer rates to ensure they are no worse-off under
a counterfactual assessment. Energy retailers all have finely-tuned modelling capabilities to
produce optimised industry average total cost estimates, and this, in our view, is a good place to
start.
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7. References
Alexander, B. (2010), “Dynamic pricing? Not so fast! A residential consumer perspective”, The Electricity
Journal, 23(6): 39-49.
Armstrong, M., (2006a), “Recent Developments in the economics of price discrimination”, in R.Blundell,
W. Newey, and T. Persson, (ed.), Advances in Economics and Econometrics: Theory and Applications:
Ninth World Congress of the Econometrics: Theory and Applications. Ninth World Congress of the
Econometric Society, Cambridge University Press, Cambridge.
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Appendix I: Monopoly Price Discrimination
Given non-trivial fixed and sunk costs, uniform prices cannot produce efficient outcomes. In
Figure A1 (LHS) the monopoly firm maximises profit by setting price pm and producing quantity
qm (where marginal cost and marginal revenue intersect). But the welfare maximising quantity is
q*. Price-quantity combination pmqm results in deadweight losses represented by the shaded
triangle.
Figure A1:
Uniform prices in the presence of non-trivial sunk costs
On the RHS, the firm is forced to produce welfare maximising quantity q* but incurs losses
equivalent to the shaded rectangle. The firm could produce quantity qac and set the price to the
point at which the Average Cost and Market Demand curves intersect (slightly above pac*). But
this produces deadweight losses represented by the triangle abc. In short, there is no tractable
solution to maximise welfare with uniform prices. But when pricing is not constrained to uniform
solutions, this intractability can be resolved.
Figure A2, while stylised, shows that in given fixed & sunk costs, differential pricing can result in
the marginal good produced being sold at marginal cost (thus maximising welfare) while
simultaneously producing a tractable financial result for the firm (with even higher profits), total
output expands, and, consumer welfare is unambiguously improved. In Figure A2 (LHS), the
regulated monopolist is constrained to uniform pricing and the financially tractable result requires
output to be set to qac and a deadweight loss arises (the shaded triangle). When differential prices
are introduced (see imputed differential prices pd in Figure A2, RHS) output expands to q* and
consequently, welfare has been unambiguously improved. There is now a dispersion of prices
paid by various consumer segments, spanning the range pd to pmc. To be clear, the most inelastic
consumers are worse-off. But total consumer welfare has been enhanced and the most elastic
consumers are substantially better-off.
Figure A2:
Output under uniform and differential pricing with non-trivial sunk costs
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We translate the imputed changes in welfare arising from differential pricing in Figure A2 by way
of Figure A3. In this example, consumer surplus (CS) and producer surplus (PS) have both
increased, and given economies of scale the firm’s average cost of production has also reduced
slightly, from pac (LHS) to pac* (RHS). Crucial to the overall conclusion that welfare has been
unambiguously improved is that output expansion followed the implementation of differential
pricing.
Figure A3:
Welfare under uniform and differential pricing with non-trivial sunk costs
The imputed discriminatory price line pd in the above figures is of course stylised. A more
technically elegant illustration would chart multiple demand curves illustrating different
curvatures for each consumer segment, with unique uniform prices in each segment.
Nonetheless, our stylised chart demonstrates a clean result. Above all, the ability to price
discriminate has removed a market power problem rather than amplify it. Recall that under
uniform prices the monopolist maximises profit by limiting output to qac.
Appendix II: Hotelling’s Spatial Model of Duopoly
Hotelling (1929) examined a homogeneous product duopoly with zero marginal cost (i.e. two
suppliers of mineral water of identical quality), competing for elastic customer demand.
In a standard Cournot (quantity-based) duopoly, firms maximise profit by observing the
production output of its rival and then adjust its own sales knowing that market prices will reflect
the total quantity put on the market. By restricting quantity a unique equilibrium can be
identified. In a Bertrand (price-based) duopoly the firm knows it can undercut its rival’s price
and substantially increase market share and profits. The rival will react and cut its own price in a
repeated game and eventually rents are competed away.
Hotelling (1929) observed that with strict Bertrand models, a firm steals the entire customer base
with a slight reduction in price. Yet in the real world inherent customer inertia exists with small
price differentials – due to convenience, lower transport costs, or loyalty. Thus in his model (see
Figure B1) key variables were added, viz. a large mass of customers distributed uniformly in
space (in regions x..z) and transport costs c. One can see that with this model, Firm B can price
differentially to customers in all segments given the transport costs facing Firm A, and vice versa.
In the price discrimination literature, c is frequently used as an avatar for the myriad of variables
driving customer inertia.
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AGL Applied Economic and Policy Research
Figure B1:
Hotelling spatial duopoly model with transport costs c
The significance of Hotelling (1929) is that this spatial approach was used to explain why sales
shift gradually (cf. abruptly) when a firm increases its price marginally and rivals hold prices
constant. Hotelling showed that in equilibrium the two firms located towards the outer ends of a
spatial model will sell their product to local customers at levels slightly below their rivals
delivered price.
Appendix III: Model Inputs
Table 1: Generation Cost and Operational Inputs
Model Variable
Plant Capacity
Capacity Factor
Auxillary Load
Thermal Efficiency
Raw Fuel
Variable O&M
Fixed O&M
Combustion Emissions
Fugituive Emissions
Carbon Price
Capital Cost
Capital Works
Useful Life
Unit
i=
MW
k
%
CF
%
Aux
%
ζ
$/GJ
F
$/MWh
v
$/MW
f
kg CO2 /GJ ġ
kg CO2 /GJ ĝ
$/t
CP
$/kW
X
$ '000
x
Years
L
Black Coal Brown Coal
QLD
1000
90.0
6.0
39.0
1.00
1.28
52,768
90.2
8.7
2,500
5,000
40
VIC
1000
90.0
7.0
28.0
0.40
0.10
36,700
92.0
8.7
3,000
5,000
40
CCGT
CCGT
OCGT
OCGT
VIC
400
85.0
3.0
50.0
5.50
4.08
10,188
50.6
18.6
1,200
2,000
30
QLD
400
85.0
3.0
50.0
6.00
4.08
10,188
50.6
18.6
1,200
2,000
30
VIC
450
n/a
1.0
35.0
6.00
10.19
4,075
50.1
5.7
732
1,000
30
QLD
450
n/a
1.0
35.0
6.50
10.19
4,075
50.1
5.7
732
1,000
30
Source: Simshauser & Ariyaratnam (2014)
Table 2: Average and Marginal Cost Assumptions
Parameter
Retail Costs
Operational Expenditure
Customer Acquisition Cost
Regulatory Fees
Retail Margin – Average Cost
Retail Margin – Marginal Cost
Network Costs (incl. metering)
Wholesale Energy Costs
Average Cost
Marginal Cost
LRET/SRES
Market charges
VEET
Energy Losses
Victoria
Queensland
($/customer)
($/customer)
($/customer)
(%)
(%)
$108.00
$45.46
$8.0%
0.0%
$108.00
$45.46
$1.83
8.0%
0.0%
($/pa)
$643.62
$822.44
($/MWh)
($/MWh)
($/MWh)
($/MWh)
($/MWh)
(%)
$84.72
$39.45
$7.82
$0.56
$9.23
5.05%
$82.55
$51.07
$8.13
$1.66
n/a
7.10%
Page 36