Markets Need Customers by Chris Trayhorn, Publisher of mThink Blue Book, April 1, 2003 The average electricity customer has fled from electricity restructuring, returned to the utility from competitive suppliers, and voted for politicians who kill restructuring. The experts say, “The customers just don’t understand, but it doesn’t matter. Once we get the wholesale market right, everything will fall into place.” Of course, in real markets, when the consumer walks away from a product offering, that means that something is wrong with the product. In the strange world of electricity restructuring,the experts tell us that something is wrong with the customer. “As for the near-bankrupt power producers and marketers, that’s what happens in a cyclical business,” they say. “There’s nothing wrong with the model.” However, maybe the customer doesn’t see a product worth buying. Maybe the supply-side debacle, in part, came about because of the disconnect between customers and suppliers. Maybe one cannot create a functionally competitive market in which only sellers can see and respond to price. It Started in the United Kingdom In the late 1980s, the Thatcher government decided to privatize the British electricity supply industry. The government hired an army of American and British consultants to develop the model. Once done in the United Kingdom, those consultants then spread the model around the world, even before anyone could show that the model produced benefits for the public. The British divided the industry into generation, transmission, distribution (local wires), and supply (sale of the energy to the public). The generators sold their electricity into a central pool, which selected generators in order of price offered, but it paid all the generators the price it had to pay to the last generator chosen (the highest price). The big buyers of electricity (such as industrial firms or local sellers to consumers) took their electricity from the pool, but they had the ability to make all sorts of side deals that protected them from price fluctuations. The pool model suffered from two serious flaws. First, an oligopoly controlled generation. Second, consumers could provide no input to the market about how much electricity they wanted to take, given a schedule or prices. When you put a small number of sellers into a one-sided (seller only) market, you create the right conditions for collusive bidding, gaming the market, and higher-than-competitive prices. That is the market model we have embraced, even though the British not only had problems with it before California stole the idea from them, but also abolished the pool in 2000 in order to try something else. What did the British actually accomplish? They showed that citizens and governments can make big money via privatizations and that stifled government bureaucracies can transform themselves into innovative enterprises. They did not demonstrate that industry structure and pool would produce significant benefits to consumers. Real Savings? From 1990 to 2000, the real price of electricity fell roughly 3 to 4 percent per year, an impressive decrease. But if you delve into the ways that the U.K. electric industry saved money, you find that the bulk of the savings came from measures that any reasonably intelligent nonpolitical management would have taken to run a competitive enterprise no matter what the structure or ownership of the industry. The companies stopped buying overpriced British coal, canceled construction of unnecessary and expensive nuclear and coal facilities, made existing nuclear plants run better, cut staff, and built efficient facilities that burned economical fuels. Requiring the industry to run efficiently and make normal commercial decisions probably accounted for half the real price reduction in electric bills. In other words, taking out the impact of what the industry should have done anyway if it had put its customers ahead of its political obligations, the real price of electricity declined approximately 2 percent per year from 1990 to 2000. Still impressive, except that the old, inefficient industry managed to reduce real prices 1.5 percent per year in the previous decade. Interestingly, the real price of electricity fell 10 percent in 2001, the first year without the pool. British suppliers have begun to build up a customer base, although still not providing the kind of price interaction that would truly integrate customers in the market. And the British generators, in some cases, have begun to accumulate their own customers. (Remember, though, that taking on customers is not the same as re-verticalizing the business. Customers nowadays can take a walk if they don’t like prices or offerings.) So far, it looks as if the British did a good job of encouraging electricity suppliers to run more efficiently, but they did not change the way people buy or sell electricity. And it is unclear what their one-sided market accomplished, otherwise, which may explain why they dumped it but not why we adopted it. Start With the Customer? In the United States, policymakers focused on a process that placated special interest groups (“stakeholders” to the politically correct) and produced short-term political benefits. Management guru Peter Drucker, however, pointed out that successful businesses design the product first, after which they design the manufacturing process. That’s what McDonald’s did to the lowly hamburger. Drucker warned, too, against innovating on a grand scale. Politicians, however, have pressed forward to create huge markets quickly. Manufacturers usually test-market their products to obtain consumer input before launching a full-scale effort. Experimental economics (for which Vernon Smith won the Nobel Price in 2002) permits the test of market designs ahead of implementation. Policymakers have preferred expert testimony and back-room negotiations to testing, though. Finally, Drucker advised that for innovation to work, somebody has to be in charge and held responsible. The planned structure puts up to six entities in charge of one or more parts of the planning and execution of the restructuring process, with none charged with getting an economically priced, reliable end product to the customer. The optimists argue that we will eventually get it right, but they are setting up regional transmission organizations (RTOs) — semi-governmental agencies — to manage markets according to detailed rules prescribed by federal regulators. (California also set up a semi-governmental agency to manage markets according to detailed prescribed rules, of course.) Drucker warned that public service institutions acquire constituencies that oppose change, which bodes ill for any efforts to move to a better structure. Ignored Customers If you peruse the thousand or more pages of federal orders and proposals for rulemaking, discussions about the customer only exceed in number the discussions of sadomasochism. That is because nobody deals with the customer as the final destination of the chain of products and services. Generators sell into a market, and the higher the price the better. The regulators haven’t figured out how to incentivize nonprofit RTOs to operate the network in a way that would reduce costs to the ultimate customer. The transmission owners collect a return based on assets, not service. The local distribution company, in many places, has been reduced to the role of a delivery vehicle for someone else’s electricity, or, in addition, that of an agent who procures electricity for consumers at market prices or prices set by regulators. Admittedly, energy service companies do try to find low-cost supplies and provide custom pricing packages for their customers, largely the big users. But those companies have not figured out how to make a profit serving small residential and commercial customers, who take more than 40 percentof the electricity and who constitute most of the customers by number. These people have seen little or no benefit from restructuring other than politically mandated rate cuts financed by bond issues that those consumers will have to pay for, with interest, later on. Most of them rely on the local distribution utility’s provider of last resort (POLR) service for their electricity. The utility may make no profit on that service and has no incentive to do anything for the customer. This setup not only strands customers but also creates risks for suppliers, because no supplier in the chain can be certain that another supplier will continue to furnish at the service level and the price necessary to keep the customer satisfied. A recent survey claimed that consumer “awareness” of electric competition has hit a six-year low, implying that dim-witted consumers cannot comprehend the manifest benefits to them of electric restructuring. Maybe, instead, we should remember that the customer is always right and maybe does not see any benefits in the current situation because there aren’t any. Back to Basics So far, electricity restructuring in the United States has produced blackouts in California; the financial collapse of the market participants supposed to lead the way; price controls; criminal prosecutions; big fees for consultants, bankers, and lawyers; and a monumental disinterest on the part of those who were supposed to benefit from the process. At least in the United Kingdom, what the consumers overpaid because of defects in the new market they collected back from the higher prices of the electric stocks they had bought during the privatization. No such luck in the United States. What was the problem in the first place? Vernon Smith makes a persuasive case that utility regulation, which requires that the utility meet any demand put on it, combined with pricing that did not distinguish between peak and off-peak usage, fostered the development of an industry whose plant stood idle for much of the time. (The load factor, or ratio of average load to peak load has hovered around 60 percent for decades in the United States. Roughly speaking, 40 percent of plant sits idle most of the time.) In addition, the prevalent pricing policy forced off-peak consumers to subsidize on-peak customers. (Costs were higher at peak, but not prices.) To tackle the problem, the restructuring process must address pricing first in order to encourage customers to control demand at peak periods, so that the utility would not have to carry so much idle plant. Without customer action, nothing happens no matter who owns the power plants or how they sell the power into the pool. Customer advocates object to this line of reasoning. They argue that customers do not want a pricing system that charges more when costs are higher, or that not enough customers will respond to price changes, or that time-of-use pricing will lead to high bills, or that needy organizations such as hospitals that cannot trim demand will face enormous charges. Those arguments miss the point. Studies show that moving a small percentage of load off of peak will exert a tremendous downward influence on price. Somebody needs to make a business out of paying those who will act when they are required to act, so that less flexible electricity consumers can avoid stiff peak charges, and not just during emergency situations when the regional transmission organization seeks help. End Users Most customers probably do not care whether they take electricity from a distant power plant or a nearby generator; whether the price hike comes about because of congestion in the transmission network or because of an increase in natural gas fuel prices; or whether a failure in service comes about because a generator broke down or because a truck hit the nearby utility pole. Under the new system, nobody is in charge of the total quality of service or total price to the end use customer. Transmission entities could conceivably focus on the service level and costs desired by the end use customer, but they don’t get paid to do that. The distribution entity could configure its network in a way that reduces its costs or pressures the transmission and generation organizations to lower their prices. But regulators prohibit it from engaging in certain cost-effective activities, want to keep the distributors as passive conduits, and set profit limits based on investment rather than customer welfare. Ideally, policymakers would like to espy the unsullied knight on white charger come over the horizon, announce “Young Lochinvar is come out of the West,” and hand the benumbed consumers to the new entity. But that will not happen. Nobody wants those consumers because nobody can make money selling to them the same electricity as the utility unless the regulator jacks up the price charged by the utility. So why not face up to reality and tell the utility to make a business out of providing whatever energy services the consumers want at the best price possible. Competitors may complain that the local utility has an unfair cost advantage. That’s another way of saying that the competitors have to charge more to offer the same service. How do consumers benefit from that sort of competition? In short, policymakers should: make one firm responsible for the end price and total service for those consumers who do not opt out; pay that firm based on how well it satisfies the needs of the consumers (as defined by the consumers); and let it do whatever it has to do (legally, that is) to satisfy that mandate. Constructing a competitive market without input from customers seems a pointless exercise. Even worse, the construction may not work. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.