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Keywords:

  • water;
  • electricity;
  • gas;
  • multi-utility firms

Abstract

  1. Top of page
  2. Abstract
  3. 1 Introduction
  4. 2 The Development of Multi-Utility Firms and the Bundling of Utility Services
  5. 3 Prospects for Bundling and the Development of Multi-Utility Firms in Australia
  6. 4 Conclusion
  7. References

In the face of rising costs of living and stagnant productivity growth in the utilities sector, this article considers the scope for the greater bundling of services and the further development of multi-utility firms in Australia. With particular reference to the water sector, the article sets out the range of factors likely to contribute to, or inhibit such developments in Australia. In summary, this article concludes that the limited economies of scope that exist between the water and energy (gas and electricity) sectors, as compared to those within the energy sector, is a primary factor restricting the potential development of multi-utility firms. It also suggests the potential scope for bundling and development of multi-utility firms is likely to be inhibited by the lack of competition in the water sector, and to a lesser degree the predominant government ownership of that sector. Nonetheless, this article suggests further work should be undertaken to more accurately assess the potential for economies of scope in the delivery of utility services. It also notes that any change to facilitate bundling as a means to lower pricing also requires pricing regulation to be adapted to address any potential obfuscation by firms.


1 Introduction

  1. Top of page
  2. Abstract
  3. 1 Introduction
  4. 2 The Development of Multi-Utility Firms and the Bundling of Utility Services
  5. 3 Prospects for Bundling and the Development of Multi-Utility Firms in Australia
  6. 4 Conclusion
  7. References

Over the five years to 2011, average household electricity prices in Australia rose by around seventy per cent (Sept qtr 2006 to Sept qtr 2011), while water prices in metropolitan centres increased on average around sixty-five per cent (Australian Bureau of Statistics, 2011a: Cat. No. 6410.0). Numerous factors contributed to these rises including large infrastructure investments aimed at alleviating the effects of drought, regulatory arrangements designed to encourage the take up of renewable energy, the mandatory introduction of smart metres, and investments in transmission and distribution networks to meet the requirements of growth. At the same time, productivity growth in a range of utility industries stagnated (Australian Bureau of Statistics, 2011b: Cat. No. 5260.0.55.002).

In the face of the heightened cost of living concerns that rising utility prices generated across the nation, the purpose of this article is to consider whether greater integration of utility service delivery – either through actual or virtual integration – could enhance efficiency and place downward pressure on utility prices. Given the limited extent of competition and private sector involvement in the water sector that currently exists in Australia, a particular focus of this article is the potential for integration and bundling involving the provision of water and wastewater services.

To this end, the article is structured as follows: 'The Development of Multi-Utility Firms and the Bundling of Utility Services' examines the economic bases for actual and virtual integration of utility service provision, and more broadly the outcomes of bundling strategies in terms of efficiency, profitability and pricing. To illustrate the potential for such activity, it also provides a brief overview of public and private sector multi-utility firms operating internationally. 'Prospects for Bundling and the Development of Multi-Utility Firms in Australia' then considers the prospects for further development of multi-utility firms and the bundling of utility services in Australia – for both monopoly firms expanding into competitive markets and, to the extent possible, participants in competitive markets moving into more regulated/monopoly areas of activity. 'Conclusion' then makes some concluding comments.2

2 The Development of Multi-Utility Firms and the Bundling of Utility Services

  1. Top of page
  2. Abstract
  3. 1 Introduction
  4. 2 The Development of Multi-Utility Firms and the Bundling of Utility Services
  5. 3 Prospects for Bundling and the Development of Multi-Utility Firms in Australia
  6. 4 Conclusion
  7. References

2.1 Literature Review

The potential development of multi-utility firms – either through actual integration or virtually through the bundling of utility services – is the subject of various streams of economic literature.

Theoretical support for the development of multi-utility firms focuses in the first instance on the potential exploitation of economies of scale and scope. Economies of scale arise where firms are able to lower the cost per unit of output with increasing scale – either because fixed costs are spread over more units of output or operational efficiencies are achieved, resulting in lower variable costs. Economies of scope occur where the joint production of a single firm is greater than the output that could be achieved by two different firms each producing a single product (with equivalent production inputs allocated between them).

The nature of, and potential to exploit, such economies – either through actual or virtual integration – has been considered in detail in bundling literature. This literature defines various different types of bundling. “Pure” bundling is where goods/services are sold only in combination, while “mixed” bundling occurs when good/services may be sold either individually or in combination.

2.1.1 Provision of Multi-Utility Services – A Firm Perspective

This bundling literature suggests that in determining whether to provide multiple utility services, or to undertake bundling, firms will have regard to a number of factors including:

  • Whether integration and/or bundling enables efficiencies to be obtained through cost savings for either the supplier or the consumer

    Integration and/or bundling can lead to efficiencies where – in combination – there are economies of scale and scope associated with the range of costs involved in the supply of bundled goods/services (Bakos & Brynjolfsson, 1997, p. 9). These costs include

    • production costs – the cost of producing additional units for inclusion in the bundle. These may extend beyond actual production to the storage, processing or communication costs incurred in the process;
    • binding costs – the cost of binding the component goods together for distribution as a bundle;
    • distribution costs – the cost of distributing a bundle of goods;
    • menu costs – the cost of administering multiple prices for a bundle; and
    • transaction costs – the cost of marketing, administering transactions, arranging for payments (see Guiltinan, 1987; Calzolari & Scarpa, 2007) and servicing customers (Papandrea et al., 2001, pp. 23–24).3 This is generally regarded as being a core benefit to producers and consumers of bundled electricity and gas services. For consumers, there is also potential savings associated with search costs. In particular, bundling may lead to efficiencies because instead of having to look around and compare different offers for multiple services, when offered as a bundle a consumer can save time and buy those services from the same provider. Issues relating to the extent of efficiencies associated with search can, however, be quite complex. For example, while bundling might reduce search costs, it may also lead to more complex price menus that impose high evaluation costs on consumers. Furthermore, if complex menus are coupled with asymmetric information,4 market failure may result (see, for example, Kephart et al., 1998), particularly if suppliers use behavioural strategies to take advantage of consumer psychology to enhance their position (see, for example, Crane, 2006, p. 438).
  • Bundling may enhance the nature of the goods/services being provided

    As well as lowering the potential cost of existing products, bundling may create efficiencies by improving the quality and functionality of the goods/services being provided. Factors underlying this outcome include

    • inherent synergies that exist between certain products (see Nalebuff, 1999, p. 2);
    • the greater capacity of suppliers to integrate goods than consumers (Nalebuff, 2004, p. 161);
    • the extent to which product differentiation may be facilitated, particularly by new entrants seeking to provide a better service offer than that available from an incumbent (see Papandrea et al., 2001, p. 9); and
    • the extent innovation is encouraged by incumbents seeking to preserve and extend positions of advantage (Choi, 1998) (as compared to bundling leading to a lessening of competition, and a dampener on innovation from rival firms).5 For utility services generally, the scope for innovation is at first blush limited given the uniformity of product provided. However, potential scope for change does exist, particularly in the energy sector through reforms such as the introduction of alternative sources of electricity production, or new pricing structures based on time of use metering.
  • Bundling may enable price discrimination by sellers

    Bundling can facilitate price discrimination by enabling multi-product discounts to segment buyers according to their relative demand elasticities. As a result, firms can increase their profits by effectively selling a greater number of goods/services to more demand-elastic customers at a lower price and a lesser number of goods/services to less demand-elastic customers at a higher price. Generally, price discrimination is beneficial to firms provided no group is charged less than the marginal cost of supplying the goods/service to them (Adams & Yellen, 1976; Schmalensee, 1982).6 Price discrimination through bundling may be beneficial for both monopolists (see Stigler, 1968; Adams & Yellen, 1976; Schmalensee, 1982, 1984; McAfee et al., 1989; Bakos & Brynjolfsson, 1999) and also suppliers without market power (see Crane, 2006, p. 437; Guiltinan, 1987, p. 76). Bundling to take advantage of price discrimination can be expected to work best when the bundled goods are negatively correlated in value. This is when bundling most reduces the dispersion in valuations and allows the monopolist to capture the lion's share of consumer surplus. Bundling still works when valuations are independent, but gains from bundling disappear with perfect positive correlation (Schmalensee, 1984, p. 228; Nalebuff, 2004, p. 160). This characteristic suggests bundling is more likely for energy related products, though potential also exists for energy and water jointly in that they are likely to be independent.

  • Bundling may create barriers to entry where a company has market power in two goods against a rival company supplying only one of those goods to the market

    The potential impact of bundling creating barriers entry is the subject of considerable discussion in the literature. Generally it has been argued it is not theoretically sensible to use power in one market to leverage into another (see, for example, Papandrea et al., 2001, p. 20; Kaplow, 1985, p. 518; see also Bowman, 1957).7 However, the counterview is that this traditional argument is based on assumptions of a market characterised by perfect competition and constant returns to scale. Under different assumptions, it is suggested bundling may create barriers to entry (see Whinston, 1990; Carlton & Waldman, 2002), including where

    • the market in which power is held is oligopolistic rather than monopolistic (see also Matutes & Regibeau, 1992; Nalebuff, 1999);
    • all markets are oligopolistic (Carbajo et al., 1990) (depending on cross-price elasticities) (though the effect depends on the relationship between the goods/services – that is, whether they are complements or substitutes (Bulow et al., 1985));
    • the secondary market is not perfectly competitive (see Whinston, 1990); and
    • there are economies of scale and/or scope (see Carlton & Waldman, 2002) and/or a requirement for risky upfront investment in research and development (Choi & Stefanadis, 2001). Furthermore, it is also argued the extent to which bundling may create barriers to entry depends on the nature of the goods being bundled – with bundling more likely to be an effective barrier to entry where goods are positively correlated in value or, to a lesser extent, if independent. However, bundling loses its effectiveness as a barrier when the goods are perfectly negatively correlated (Nalebuff, 2004, p. 160).
2.1.2 Multi-Utility Service Provision and Bundling – A Policy Perspective

While there are various factors that may encourage firms to provide multi-utility services or bundle products, issues of interest for policy-makers (as well as firms) are generally broader.

2.1.2.1 Firm Profitability and Consumer Surplus

In considering the merits of policies in support of integration and bundling, regard needs to be given to broader economic outcomes such as the extent to which bundling has a positive impact upon profitability as compared the extent to which it enhances consumer surplus. In large part, the potential for increased profitability through bundling has been associated with the capacity of firms to engage in price discrimination (Papandrea et al., 2001). Adams and Yellen (1976), for example, demonstrated that a multi-product monopolist can increase its own profits through pure or mixed bundling in a variety of circumstance. Schmalensee (1984) also showed that bundling can be profitable even when demands are uncorrelated or even positively correlated. His explanation for the profitability of bundling was that it reduces the effective dispersion of reservation values, therefore making it possible for the seller to extract a greater portion of potential surplus.

While increased profitability from bundling may come at the expense of the consumer, such a detrimental consumer outcome will not necessarily always be the case. As noted above, it is possible for multi-utility firms and bundling practices to improve efficiency and hence be welfare enhancing – the benefits of which may be shared between both firms and consumers. Further, in particular circumstances it is possible bundling may result in decreased profitability. For example, as Papandrea et al. (2001, p. 11) note, bundling may result in a “prisoner's dilemma” where simultaneous decisions of competitors lead to a suboptimal outcome for each of them (see Economides, 1993), or act to reduce both profit and welfare but boost consumer surplus when goods from different businesses are bundled where there is otherwise an intrinsic shopping cost of consumers purchasing the bundled goods from different suppliers in different locations (see Armstrong & Vickers, 2008). More broadly, as Salinger (1995, p. 94) notes, “the effect of bundling on consumer surplus depends on the precise distribution of reservation values.” A similar conclusion was reached previously by Schmalensee (1982, p. 71), who found that a profitable switch from unbundled to mixed bundled sales “may increase or decrease net surplus; it all depends on the details of the distribution of reservation prices.”

Amongst the factors that may influence how integration and bundling may impact on firm profitability and consumer surplus are the form of bundling adopted, the relationship between the goods/services being bundled, industry structure, cost structures and consumer tastes. With respect to the impact of industry structure, it is generally the case that for monopolists some form of bundling is the optimal strategy (cf. individual component sales), but the optimal strategy will depend upon prevailing levels of costs and the distribution of consumers in the reservation price space (Adams & Yellen, 1976).8 Furthermore, according to Armstrong and Vickers (2008), for consumers who may buy one product from one firm and another product from another firm under non-linear pricing, bundling generally acts to reduce welfare and to boost consumer surplus (although this analysis incorporates existence of extra shopping cost to consumers if they purchase products at different locations).

2.1.2.2 Pricing

Having regard to the focus of this article on cost of living issues, it is necessary to briefly touch on how bundling practices manifest through the pricing mechanism, particularly given the pricing structures associated with utility services.

In utility businesses pricing for goods and services can be complex due to high proportions of fixed costs and, more importantly, the presence of economies of scale. In such circumstances, short run marginal costs pricing is not effective as it does not cover fixed costs. This in turn leads to development of multi-part pricing to cover access costs and usage cost. The presence of multi-part pricing provides a viable platform for bundling as there are more potential elements with which to determine prices within a particular bundle.

Generally, when firms engage in bundling there is potential for both lower and high price outcomes. Lower price outcomes will generally arise as a result of efficiencies gained from economies of scale and scope which can then be passed through to consumers. However, in regulated markets, the effect on pricing could depend upon how those economies are achieved. If bundling leads to efficiencies at the wholesale level it would be necessary that this feeds into access prices charged for retail-minus inputs, otherwise access prices would be set too high, competition would be constrained and bundling would enable utility service providers to leverage market power. In contrast, if retail efficiencies fully explain a bundled discount, no adjustment to any retail minus formula related to the wholesale product is necessary.

However, higher prices may be expected where firms take advantage of their capacity for price discrimination, or utilise bundling to create barriers of entry for competing firms. In this regard, there is a risk bundling may be associated with higher prices (compared with those for independently valued goods) not only for goods/services which are complements but also for most substitutes (Venkatesh & Kamakura, 2003). Furthermore, bundling may be associated with high prices where it is used as a means of obfuscating price and as such a tool against consumers, or to encourage collusion amongst suppliers (Baranes et al., 2010).9

2.2 Development of Multi-Utility Firms – International Experience

In light of this theoretical support it is perhaps unsurprising that a large variety of multi-utility firms have developed over the past three decades. However, the pace and nature of change – which has encompassed both substantial horizontal and vertical disaggregation of utility businesses, and then the subsequent reintegration of various constituent elements – has varied substantially across the globe.10 Moreover, the presence and genesis of multi-utility firms and the bundling of utility services is far from uniform, and the experience varies amongst both public and private sector utility service providers.

In the United Kingdom, for example, major reforms in the utility sector led to some integration in the energy sector (between private gas and electricity providers), but little in the way of permanent convergence between the energy and water sectors. Energy companies have at various stages bought into the water sector, but in the main subsequently sold out these holdings. The privately owned RWE, for instance, purchased Thames Water in 2001 but then sold it in 2006. It also bought into American Water in 2003, but subsequently sold out in 2009. Similarly, from 1990 United Utilities held water, gas and electricity assets, but in more recent years has divested itself of a range of energy assets and concentrated on water and wastewater services. Investors in utility services in the United Kingdom now tend to be industry specific – with new investment in the water sector coming from overseas water (e.g. Veolia, Osprey) and energy (i.e. RWE, EDF, E.ON) companies respectively. Some diversification of the water companies has occurred, but this has tended to be into water and environmental infrastructure development (McGuinness & Thomas, 1997; Thompson, 1999).

In contrast, in Europe, there are numerous instances of large, integrated utilities that operate across a range of utility services, and have done so for many decades. These include, for example, the majority publicly owned Mainova, a water, gas and electricity provider based in Frankfurt, Germany; as well as companies such as RWE, the Germany-based conglomerate providing water, electricity and gas services throughout Europe, “Suez-Lyonnaise” and Veolia, the French-based conglomerates providing water, energy management, waste and transportation services and Endesa SA, a multi-utility service operator and provider in Spain. On a smaller scale, there are also numerous entities owned by local governments which operate in water, gas and electricity sectors – for example, in Italy (see Fraquelli et al., 2004)11 and Switzerland (Farsi et al., 2007).

Similar integrated utility firms operate elsewhere around the world. In Singapore, for example, the privately owned Sembcorp provides bundled electricity and water services for industrial customers. Sembcorp also owns various other infrastructure assets around the world, including a small water company in England. In Medellin, Columbia, Empresas Públicas de Medellín is a publicly owned entity operating as an integrated water, electricity and gas provider, while in Morocco, Lydec (Casablanca), Amendis (Tangiers and Tetouan) and Radel (Rabat) each provides water, wastewater and electricity services in their concession areas. In the United States, the Los Angeles Department of Water and Power supplies both water and electricity services. However, this reflects the exception rather than the norm in the United States. While there has been substantial convergence in the energy sector as far back as the 1990s (e.g. Houston Industries/NorAm Energy, Enron/Portland General Electric, Duke/PanEnergy) (Meritet, 1999), this integration of utilities generally does not appear to extend to include water and wastewater services.

Finally, while examples of integrated utilities abound, so too do examples of specialisation. In the water sector, for instance, the provision of water and wastewater services have been separated completely between two public sector entities in Tunisia, while in the United Kingdom a hybrid approach has been adopted by private sector participants where some entities are involved solely in one part of the industry, that is, water supply, while other entities provide both water and wastewater services. Similarly, in the energy sector there are myriad examples of both independent and combined provision of gas and electricity services, and specialist service provision within the various components (production/generation, transmission, distribution, retail) of each industry.

2.2.1 Empirical Evidence

Such diversity in approach reflects in part the fact that while there are many examples of multi-utility firms, including firms that incorporate water services, there is only limited empirical evidence regarding the success or failure of integration across utility sectors and more specifically the bundling of utility services (see Fraquelli et al., 2004; Farsi et al., 2007). For developed countries, such evidence as is available indicates as follows12 :

  • with respect to combined gas and electricity utilities, Mayo (1984) reported scope economies for small companies only; Sing (1987) found that an average combination of utilities exhibited diseconomies of scope, while other output combinations were associated with both economies and diseconomies of scope, while Chappell and Wilder (1986) found scope economies over most output ranges;
  • examining Canadian water and electricity service combinations, Yatchew (2000) suggested that economies of scope of between seven to ten per cent were achievable;
  • in considering Italian multi-utility service providers, Fraquelli et al. (2004) (see also Piacenza & Vannoni, 2004)13 found that global and product specific economies of scope, as well as global return to scale, for multi-utilities smaller than the “median” firm.14 For larger units, notwithstanding estimates point to the presence of both aggregate economies of scale and scope, the large standard errors are such that the hypothesis of constant return to scale and null advantage from diversification cannot be rejected. They concluded that “… keeping into account the fact that local public services have not yet been fully privatised/liberalised in most countries, one has at best to be cautious in expecting large welfare gains from diversification moves involving large players”;
  • with respect to Swiss multi-utilities (which are generally of smaller scale), Farsi et al. (2007) concluded the existence of significant scope and scale economies in a majority of multi-utilities, which can be considered as suggestive evidence of natural monopoly in multi-utilities, and that there was considerable variation of the estimated values among individual companies, which suggested that the economies of scope and scale can depend on unobserved network characteristics as well as output patterns and customer density. They argued “[t]he results … show that even after accounting for unobserved heterogeneity, the scope economies exist in a majority of the multi-utilities, suggesting that additional costs could result from unbundling the multi-utility companies. … Especially for small companies the savings associated with scope economies are considerable.”

3 Prospects for Bundling and the Development of Multi-Utility Firms in Australia

  1. Top of page
  2. Abstract
  3. 1 Introduction
  4. 2 The Development of Multi-Utility Firms and the Bundling of Utility Services
  5. 3 Prospects for Bundling and the Development of Multi-Utility Firms in Australia
  6. 4 Conclusion
  7. References

Both the literature and international experience provides some support for the development of real or virtual bundling of utility services in Australia – and certainly from a firm perspective. However, it also suggests that while the case for integration and bundling of gas and electricity services is fairly straightforward, the benefits of firms providing both water and energy services is less clear.

3.1 Australian Experience to Date

Like the rest of the world, Australia's experience with multi-utility firms to date has also been diverse. Of the major entities operating in the water sector there are two – in the Northern Territory (Power and Water Corporation) and the Australian Capital Territory (ACTEW) – that have historically been involved in the provision of multiple utility services. The Power and Water Corporation is a publicly owned corporation and monopoly service provider of water and energy services that gives customers combined bills.15 ACTEW is a publicly owned corporation that owns the Australian Capital Territory's water and sewerage assets, and a fifty per cent interest in the ActewAGL joint venture. This joint venture between ACTEW and the privately owned AGL and Jemena comprises two partnerships – one involved in the retailing of energy, the other operating electricity and gas networks. Until 30 June 2012, it also managed the water and sewerage network on ACTEW's behalf. ActewAGL bundles a range of utility services to households and businesses (such as electricity, gas and telecommunications services), but these bundling arrangements do not include the provision of water and wastewater services.

In each of the other State jurisdictions, water and energy services are provided by entirely separate entities. There is, however, considerable diversity as to how these service providers are structured. In the water sector, providers range from a single, publicly owned, vertically and horizontally integrated entity that operates across an entire State (e.g. Western Australia's Water Corporation) to ones operating within a far more disaggregated, metropolitan-based structure (e.g. Melbourne Water, Yarra Valley Water, South East Water and City West Water in Melbourne, Victoria). Generally, there tends to be an integration of both water and wastewater services, although the approach taken is far from uniform. In Perth, Adelaide and Sydney, a single entity is responsible for the provision of these services, whereas both Melbourne and Brisbane/South East Queensland provide examples of more disaggregated approaches (Abbott & Cohen, 2010).

In the energy sector, there are many examples of privately owned, integrated providers of gas and electricity services (e.g. AGL, Energy Australia and Origin). However, these energy services providers also tend to separate out the provision of network elements (i.e. distribution and transmission services) from other aspects of energy provision.16 As the water and energy sectors are in the main structurally separate in Australia, the extent of bundling of utility services which has occurred to date in Australia has been limited and concentrated primarily in combining electricity and gas bills.

3.2 Implications for Australia

Both the literature and international experience provides guidance as to the potential for actual or virtual integration of utility service provision. Looking first to the energy sector, a range of reasons have been elicited as to why the development of combined gas and electricity utilities, and the adoption of bundled service provision, has already occurred. First, there is the potential for cost efficiencies associated with such combined service provision. As noted previously, the available evidence with respect to economies in joint production is mixed. However, there has certainly been a tendency for electricity companies to become involved in gas developments and vice versa. In part this may stem from the capacity of gas to be used both as energy source in its own right, and also as a feedstock for electricity production. In this regard, combining electricity and gas production activities is consistent with a strategy of internally hedging – a practice that more broadly manifests through the integration of generation and retail activities. Secondly, the relationship between the energy products – in particular, that as substitutes they are negative correlated in value – facilitates the adoption of a mixed bundling strategy insofar as it enables price discrimination (though conversely restricts its use as a barrier to market entry) (Nalebuff, 2004). Thirdly, firms operating within the energy sector do so within a predominantly competitive market framework (particularly in generation and retail of gas and electricity), which means that companies are not seeking to protect pre-existing monopolistic prices or returns. Combined, these factors encourage both integration and bundling.

However, the same literature suggests the development of multi-utilities in Australia incorporating both energy and water activities is a more complex issue – particularly from a broader community welfare perspective.

At first blush, a strategy of integration of water and energy services would appear viable in that the basic economic attributes in both sectors – significant sunk costs, low price elasticities, large fixed costs and low marginal costs of production – lend themselves to combined service provision and viable bundling strategies (see Papandrea et al., 2001, p. 22). There are, however, other factors that have tended to positively encourage energy and water companies to move away from each other rather than combine; that is, the water sector moving into waste and environmental management (e.g. Veolia), and energy companies to mineral resource development (e.g. AGL).

In the first instance, the economies of scope that exist between the water and energy sectors appear to be limited. It is possible there may be some efficiencies in joint production – in areas such as pipe construction and operation, hydro-electric generation from water storages, and the utilisation of the water utilities’ energy demand as a risk management tool to balance overall electricity usage, and hence generation, profiles.

However, the clearer potential benefits that could be expected to be associated with the development of multi-utility firms involving both the energy and water sector centre around efficiencies with respect to transaction costs – through mechanisms such as common billing systems, integrated call centres, combined metre reading processes and joint marketing.

Efficiencies of this type are, however, proportionally quite small in terms of the overall cost of utility service provision, and also reducing over time as technology enables innovation in these areas. In the case of electricity the proportion of costs associated with the retailing of electricity – as compared to the generation, transmission and distribution – has been estimated at around five to ten per cent of total costs (Abbott, 2002). Similarly, in the water sector, retailing only accounts for around five per cent of total costs. As such, any gains that may be made from integrating billing systems across utilities can be expected to have only limited impact on final prices, particularly once transitional costs have been incorporated and where efficiency benefits have been achieved through specialist outsourcing. Furthermore, there is also a potential risk that integrating billing systems across multiple utilities would create a greater level of complexity that may impinge on the extent to which those systems can be utilised to enhance service quality through improved customer interactions (such as responding to requests for fault rectifications).

The integration of water and energy utilities also brings with it other risks and complexities. For example, there may be some potential – at least in the short term – for the development of multi-utility firms to lower prices as firms cross-subsidise water services with revenues from energy sales (if permitted by law) so as to build market share. However, whether such an outcome would actually occur is unclear. As Schmalensee (1982) noted, such a pricing strategy is likely to be of limited benefit where it involves the monopoly provision of one product/service and competitive provision of another. In the Australian context, the still monopoly and price regulated position of the water suppliers in contrast to the more competitive markets faced by the electricity and gas retailers would act as a substantial impediment to this kind of pricing behaviour.

And even if such pricing behaviour did occur, the overall benefits are not clear cut. While lower prices would ostensibly be regarded as positive, whether such an outcome results in net community benefit is itself far from certain – particularly given the extent to which the water sector in Australia is predominantly publicly owned.

On the further question of efficiency, to the extent that cross-subsidisation from the water sector would result in lower energy prices than would be set in a purely competitive environment, this could result in energy usage being distorted. At an institutional level, it is also likely to be of concern if governments – being both regulators and owners – were able to place water utilities in an advantageous position against privately owned energy firms. The potential that publicly owned water utilities could encroach into the predominantly privately owned energy sector could be expected to act as a barrier to investment by those private sector firms. This would be particularly so given the range of economic, regulatory and policy barriers that operate to inhibit the scope for the private sector to operate in the Australian water sector, and hence prevent those entities from undertaking such integration and bundling activities.

Given such concerns, it is reasonable to suspect any move towards enabling greater integration or bundling of utility services would need to be accompanied by structural changes that enabled either greater competition in the water sector and/or scope for greater involvement by private sector utilities. However, this itself gives rise to the potential cost of the loss of monopoly control for existing owners – which in the case of the water sector in Australia are the States and Territories.

To some extent, the risks associated with price discrimination in the water and energy sectors in Australia are ameliorated by the pricing regulatory arrangements that operate across the country. However, there is a risk that both real and/or virtual bundling of utility services could make the regulation of utilities more complex, less transparent and less effective.

Notwithstanding these regulatory issues, Calzolari and Scarpa (2007) still concluded that there was benefit in permitting multi-utility firms so as to enable advantage to be taken of the integration benefits that may come from the development of multi-utility firms.17 However, such concerns give substantial weight to Chaaban (2004) suggestion that the emergence:

of multi-utility firms requires increasingly sophisticated theoretical and practical regulatory mechanisms that could cope with and ultimately facilitate these kind of changes – particularly where combines competitive and monopolistic elements. Further, the type of regulatory model to apply may differ depending on whether full information available or information asymmetry exists between incumbent and regulator; nature of interaction between incumbent and regulator and extent of economies of scope which may exist as a result of integration (which could be lost if, for example, regulation required structural separation to occur.

4 Conclusion

  1. Top of page
  2. Abstract
  3. 1 Introduction
  4. 2 The Development of Multi-Utility Firms and the Bundling of Utility Services
  5. 3 Prospects for Bundling and the Development of Multi-Utility Firms in Australia
  6. 4 Conclusion
  7. References

In Australia concerns regarding the level and increases in water, gas and electricity prices are widespread. In an environment where much structural reform has already occurred, the issue considered by this article is whether further reform – primarily focusing on the development of multi-utility firms and bundling of utility services – could provide a potential avenue to reducing price pressures.

In considering this issue, it is recognised that much of the reform focus of the past twenty years has focused on the vertical and horizontal disaggregation of utility businesses. The purpose of this article is not to suggest a return to previous arrangements, but rather whether in light of other changes that have occurred – including the introduction of competitive market structures and transparent pricing regulation – some further efficiencies may be gained from greater integration of utility service delivery.

It would appear, however, that the theoretical and empirical support for such reform is far from conclusive. In the first instance, the limited economies of scope that exist between the water and energy (gas and electricity) sectors, as compared those within the energy sector, restricts the potential for multi-utility firms to develop more widely as a means to impose downward pressure on utility prices in Australia. Furthermore, the potential scope for bundling by multi-utility firms is restricted by the lack of competition in the water sector, and to a lesser degree the predominant government ownership of that sector.

While the case for change is therefore not strong, it can still be expected there will be some ongoing pressure to enable bundling of multiple utility services to occur. As Granier and Podesta (2010) observe, the potential for bundling always creates merger incentives for specialised firms (in their case, electricity or gas firms).18 From an agency perspective Montgomery (1994), similarly argues pressures will also arise as a result of management preference for creating and working in larger organisations. Indeed, it can reasonably be expected individual reasons of business strategy – rather than the achievement of desired public policy outcomes – are the factors most likely to drive greater development of multi-utility businesses.

Given there is likely to be ongoing business-driven pressures for change, coupled with the level of ambiguity that is associated with this reform, it would appear constructive for additional work to be undertaken to better assess the potential economies of scope that exist between water and energy service provision in an Australian context. However, it is also the case that should any government wish to consider reforms of this nature, it should recognise that such change should be coupled with reform that enhances transparency in pricing regulation and, to the extent possible, encourages greater competition in the water sector.

Notes
  1. 2

    Prior to publication, one of the paper's authors was engaged to undertake a Review of Institutional Arrangements for ACTEW Corporation Limited. For completeness, it is noted that this article was originally submitted before the commencement of that task, and does not rely upon ACTEW-related information not already in the public domain prior to the start of that Review.

  2. 3

    For example, where products are bundled only one customer hotline may be required to deal with inquiries or issues.

  3. 4

    For new entrants, however, bundling helps overcome problems associated with limited information with respect to customer tastes (and the difficulty/cost of determining that for each customer).

  4. 5

    This effect may even be welfare enhancing if it prevents duplicative spending on innovation with respect to the same products by different firms.

  5. 6

    In addition, bundling may reduce uncertainty for consumers with respect to pricing. In this regard, there is growing evidence consumers prefer “certainty” over “uncertainty” with respect to prices. When offered choices between fixed-fee (subscription) pricing versus per-use pricing, many consumers tend to select a fixed-fee scheme, even when that results in higher overall costs for the consumer (Fishburn et al., 1997). Also as noted by the United States Federal Communications Commission (Federal Communications Commission, 1997, p. 63), “customers have shown a strong preference for simple pricing systems” (Papandrea et al., 2001, p. 25).

  6. 7

    The essence of this argument is “that a company with a monopoly in good A gains no advantage by only selling A as part of a bundle with a competitively supplied product B. The reason is that good B is freely available at its marginal cost. Thus, consumers evaluate an AB bundle by whether A is worth more than the incremental cost of the bundle over B alone. Anyone who buys the bundle would also be willing to buy A alone, at the same profit margin for the monopolist. In fact, the monopolist would typically do even better by selling A alone as some customers who would buy A alone would not choose to buy the bundle” (Nalebuff, 1999, p. 4; see, for example, Director & Levi, 1956; Schmalensee, 1982, for a more formal argument).

  7. 8

    In this context, Adams and Yellen (1976) argue mixed bundling at least weakly dominates pure bundling (though it presumes no costs saving from bundling). McAfee et al. (1989) have shown absent cost savings that mixed bundling virtually always dominates pure bundling, although the optimal bundled price is greater than combined component prices – therefore sellers need to be able to prevent individual purchase.

  8. 9

    Baranes et al. (2010) also showed that “mixed” bundling would in fact hinder such collusion.

  9. 10

    See Pollitt (1997), Steiner (2000), Abbott (2002), Asia Pacific Economic Cooperation/ABARE Economics (2002) and Abbott and Cohen (2010).

  10. 11

    Cape Verde, Colombia, Costa Rica, Gabon and Morocco are also examples of countries where state owned enterprises have provided multiple utility services (Sommer, 2001).

  11. 12

    There is also some support for the finding that the integration and bundling of utility services improves welfare in developing nations when used to increase provision of basic services – with the benefit arising either due to economies of scope or because access to more than one utility service enables step change in welfare (see, for example, Chong et al., 2004). However, it is beyond the scope of this article to consider the role of multi-utility firms and bundling in this context, which tends to relate in the first instance to issues of access to utility services.

  12. 13

    Piacenza and Vannoni (2004) concluded that “specialised firms could reduce their costs by evolving into multi-utilities providing network services such as gas, water and electricity.”

  13. 14

    Those producing about 71 m3 gas, 11 million m3 water and 221 m kwh of electricity.

  14. 15

    In September 2013, the Northern Territory announced its intention to restructure and separate the competitive and monopoly elements of the Power and Water Corporation.

  15. 16

    In New Zealand a similar situation prevails where companies such as Contact Energy, Genesis Energy and Mercury Energy provide bundled electricity and gas.

  16. 17

    The issue of appropriate regulation also highlights one further potential area where the development of multi-utility firms offers potential efficiency – that is, in the improved capacity of firms to deal with extensive legislative and regulatory oversight in that integration enables greater utilisation of skills involved in affecting outcomes in policy and regulatory environments.

  17. 18

    The model which they adopted showed that such firms always have an incentive to bundle if a merger is achieved, and further that there would be no incentive to merge if bundling were not possible.

References

  1. Top of page
  2. Abstract
  3. 1 Introduction
  4. 2 The Development of Multi-Utility Firms and the Bundling of Utility Services
  5. 3 Prospects for Bundling and the Development of Multi-Utility Firms in Australia
  6. 4 Conclusion
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