Strategic price setting of incumbent utilities in competitive electricity markets

The current discussion on restructuring the European Electricity Supply Industry (ESI) is dominated by the assumption that there are bright prospects for cheap electricity - at least for large industrial (so-called eligible) customers(2) - due to liberalization and competition triggered by the guideline of the European Commission (EC (1997)). In this context a hopeful role is played by new electricity suppliers, e.g. Independent Power Producers (IPPs). On the one hand, it is widely assumed that they will contest historically established electricity markets and supply market shares in the eligible customers segment. On the other hand, eligible customers will also negotiate new more attractive - electricity price contracts with their historical supplier, the incumbent utility. The major purpose of this paper is to investigate whether the incumbent utility as former monopolist in its franchised supply area has - at least in the short run - market power to influence the new market price and its remaining market share in the eligible customers sector strategically. Moreover, the analytical model indicates that the incumbent utility - acting as price setter - is pushed in two opposite directions: (i) On the one hand, price reductions - compared to the historical price contract - are necessary to satisfy eligible customers and to ensure future market shares in this segment. (ii) On the other hand, preferred high prices signal competitive suppliers like IPPs that the return-on-investment is high and contesting market shares in the eligible customers sector is attractive. Resulting parameters influencing incumbent utility's pricing strategy are: (i) expected price-bids offered by competitive IPPs, (ii) incumbent utility's production cost, (iii) incumbent utility's interest rate, and (iv) "changing speed" of eligible customers towards IPPs. The major conclusions are that at least in the short run market prices can be set strategically by the incumbent utility to ensure corresponding future market shares in the eligible customers segment. Mainly because of historical grown structures only in a few Western European countries the conditions for an emergence of IPPs on a large scale - which have to be also interested in high returns-on-investment - are encouraging in the near future.