Price Discrimination in the Nsw Electricity Market

ECON5110

MANAGERIAL ECONOMICS

ASSIGNMENT 2 - GROUP

PRICE DISCRIMINATION IN THE ELECTRICITY MARKET

In Australia there are many markets which are actively pursuing price discrimination. We have chosen to look at the electricity market due to the combination of factors. Firstly, the wholesale electricity market has been deregulated in Australia over the past 20 years. And secondly, the retail electricity market has two-tiers, of which the first-tier has tariffs regulated while the second-tier does not have any regulation and is free to practice price discrimination. The electricity market also involves a mix of the different degrees of price discrimination.

Price discrimination is achieved by charging different prices to different buyers for a product. According to Boyes (2003), there are three types of price discrimination. These are perfect price discrimination, second-degree price discrimination and third-degree price discrimination.

Perfect price discrimination occurs when each customer is sold the product at the highest price each customer is willing to pay (Frank 2003). Under perfect price discrimination the company is maximising its revenue and therefore there is no consumer surplus. In practice, this level of price discrimination is impossible to obtain as it is extremely difficult to segment that market to an individual extent.

Second-degree price discrimination is the practice in which in the price changes according to the quantity purchased. This is used by a number of retailers in the electricity market, where it is known as declining tail-block rate structures. In these structures the price paid usually decreases once a certain usage level is reached (Frank 2003).

Finally, third-degree price discrimination occurs when there are different groups of customers who pay different prices for the same product. In the case of third-degree price discrimination, the company charges a higher price to the group of customers with demand that is less elastic with respect to price in order to maximise profits (Frank 2003). This is achieved by segmenting the market according to the elasticity of demand of the groups of customers and setting pricing accordingly for each of those groups

Electricity in Australia is provided to consumers via two markets; the wholesale and retail. The wholesale market, named the National Electricity Market (NEM), is for trading between generators and retailers and large end use customers (Energy Futures Australia). The Australian Energy Market Commission (AEMC) sets the rules for the operation of the NEM and "Systems through which prices are set and transactions carried out" within the NEM are created by the Australian Energy Market Operator (AEMO) (Market & Power Systems). The NEM is regulated by the Australian Energy Regulator (AER).

The retail market, on which this paper primarily focuses, is for trading by retailers to end-use customers. In the mid 90's this market moved from a monopoly arrangement to a competitive deregulated market where customers are contestable, i.e. they can choose which retailer they would prefer to purchased their electricity from (Energy Futures Australia).

The retail market consists of a two tier system (Energy Futures Australia). In New South Wales there are three first-tier retailers, namely EnergyAustralia, Country Energy and Integral Energy. Each of these first-tier retailers are divided geographically and are responsible for the construction and maintenance of the distribution network i.e. the poles and wires within their geographical area (Energy Futures Australia). These retailers can sell electricity anywhere within the state and are not limited to their area.

First-tier retailers have their tariffs regulated by the Independent Pricing and Regulatory Tribunal of New South Wales (IPART) for customers that choose to be supplied under the Standard Form Customer Supply Contract rather than negotiated contracts (Regulated Retail Tariffs). Second-tier retailers have no involvement in the distribution network and operate as stand-alone businesses. There are currently 23 second-tier retailers within NSW (IPART). These retailers do not have their tariffs regulated and customers negotiate individual supply agreements with them.

The regulations surrounding the NEM are there to ensure that the second-tier retailers are able to access the networks of the first-tier retailers at a rate which is equal to the marginal cost of supplying access incurred by the first-tier retailer. In practice it is difficult for the regulator to set this price exactly equal to the marginal cost (King 1999). King 1999 argues, that in terms of wholesaling, 'retaining an integrated utility and allowing that utility to price discriminate may lead to lower prices and a higher level of social welfare than if the utility was vertically separated and price discrimination was made illegal. Put simply, price discrimination may hurt competitors but benefit consumers.'

Price discrimination within the two markets is achieved quite differently. According to Part 2 Division 2 of the New South Wales Electricity Supply Act 1995:

"It is unlawful for a wholesale supplier to supply electricity to any persons on terms that are less advantageous than those on which the wholesale supplier supplies electricity to other persons."

However, the NEM uses dynamic spot pricing based on current levels of demand (Market & Power Systems). Pricing changes every 5 minutes and these prices are capped at a high of $12,500/MWh to a low of $-1,000/MWh (The National Electricity Rules 2010, Chapter 3, p 150). In this case, although all wholesale customers are being charged the same rate at any given time, this is still a form of profit maximisation as the wholesaler is charging what the market will bear. The marginal cost of a wholesaler "...is the dollar amount that needs to be spent to generate an additional kWh, over and above the fixed costs associated with the initial investment and operation" (Economics of Renewable Energy Plants). An example of a factor that would increase the marginal costs for coal fired electricity would be the cost of additional coal to produce a larger output. As such, marginal costs are minimal if demand stays within the generating capacity of the wholesaler. Once this generating capacity is reached further infrastructure is required and a large capital cost is incurred which is ultimately passed onto the consumer.

The retail market price discriminates in a number of ways. Interestingly