Nonlinear Pricing and Tariff Differentiation: Evidence from the British Electricity Market.

• Author: Davies, Stephen

1. INTRODUCTION

   Nonlinear pricing is frequently observed in liberalised energy markets and other oligopolistic markets. Yet the theory of oligopolistic nonlinear pricing (or second degree price discrimination more generally) remains incomplete. However, two papers (Armstrong and Vickers, 2001 and Rochet and Stole, 2002) derive the striking result that, in any symmetric equilibrium, firms will offer single two-part tariffs which are cost-based in the sense that marginal prices are equal to marginal costs.

   This paper compares these and other theoretical predictions with outcomes immediately after liberalisation of the British household retail electricity industry. Each oligopolist offered a single two-part electricity tariff, but inconsistent with the theory, the two-part tariffs were heterogeneous across firms. Throughout the time period and across all geographical regions, entrants typically selected tariffs with a higher fixed fee and a lower marginal price than the incumbent. There were also systematic variations amongst the entrants' tariffs which increased over time. These tariff asymmetries cannot be attributed to explanations such as asymmetric costs or the existence of brand loyalty. Instead, we present evidence that firms differentiated their tariff structures, with some firms offering tariffs that were relatively more attractive to lower volume consumers and other firms offering tariffs relatively more attractive to consumers with higher usage. By the end of the period studied in 2005, the six major firms collectively offered a range of two-part tariffs which qualitatively resembled a monopolist's optimal menu of two-part tariffs, a finding for which there is no current theoretical explanation.

   Empirical literature on nonlinear pricing has expanded considerably in recent years. Leslie (2004) estimates the welfare effects of price discrimination at a Broadway theatre; Cohen (2008) demonstrates that 35-45% of the unit price variation in paper towels is consistent with price discrimination; and several papers show how increases in competition can i) increase the number of pricing options offered by firms (Borzekowski et al., 2009 and Seim and Viard, 2011); and ii) reduce the level of firms' tariffs, with a greater reduction for higher usage consumers (Miravete and Roller, 2004; Busse and Rysman, 2005; and Seim and Viard 2011). In addition, McManus (2007) examines the empirical implications of Armstrong and Vickers (2001) and Rochet and Stole (2002) in the context of product size. In this context, the prediction of cost-based pricing and the resulting lackof distortions in consumption imply that firms should offer socially optimal product sizes. McManus confirms this prediction within the most competitive product category of the specialty coffee market.

   However, by concentrating on empirical regularities at the market level, the literature has paid little attention to any differences or 'asymmetries' between firms' pricing strategies. These form the main focus of our paper. Miravete (2011) considers tariff asymmetries in the early US cellular industry, finding that the incumbent's tariffs were more often dominated by the entrant than vice versa. In our oligopoly context, we also find that entrants' tariffs dominated the incumbent's in approximately 25% of cases. However, our paper differs from Miravete by focusing on asymmetries in tariff structures, rather than tariff levels. We employ a simple summary statistic for any two-part tariff, the ratio of the fixed fee to variable fee, which we term the Fixed to Marginal (FM) Ratio. Our results show an increasing tendency for each entrant's FM ratio to differ systematically relative to both the incumbent and the other entrants, with the effect of segmenting the market according to consumption volume.

   The next section introduces the market and section 3 summarises recent theoretical literature. The data and initial findings are presented in section 4. The remaining sections further explore the heterogeneity amongst firms' tariffs: section 5 considers some possible explanations and section 6 documents how the heterogeneity is robust and systematic in a way consistent with market segmentation. Section 7 concludes.

2. THE MARKET

   The electricity industry in Great Britain comprises four vertical stages: generation, transmission, distribution and retail. We focus on the retail sector, which was traditionally separated into 14 geographical regions, each with an incumbent monopolist; consumers were only able to buy from their local incumbent, and arbitrage was not possible. The industry was privatised in 1990/1, and the household retail sector opened to competition in 1998/9. Thereafter consumers were free to switch away from their incumbent (or any subsequent supplier) to any provider within their region without financial penalty, resulting in significant entry. The average prices of incumbents (although not those of entrants) continued to be regulated until April 2002, but with no effective regulatory constraint imposed on tariff structures for any of the suppliers (Harker and Waddams Price, 2007). Indeed, permission for alternative tariff structures was confirmed in the Electricity Act 1989 which explicitly permits (without mandating) two-part tariffs (Section 18(3)).

   Firms are required to offer three alternative payment methods (standard credit, direct debit and prepayment) and typically offer different tariffs for each. (1) As these payments methods are so distinct, consumers have clear preferences over them and rarely change their chosen method (Ofgem, 2008). Consequently, we consider them as three separate markets, catering for self-selecting consumers who opt for different billing arrangements, rather than as a single market with multiple tariff options.

   Following liberalisation, there was almost 100% cross-entry by the original regional incumbents into each others' markets. The incumbent gas supplier, British Gas, also entered all regions, as did a few small Independents. However, the Independents gradually exited, and there was steady consolidation amongst incumbents. By autumn 2002, the surviving electricity retailers had consolidated into 5 large companies, referred to here as the 'Majors'. By early 2006, these firms (each owning ex-incumbents in two or three regions) and British Gas were the only suppliers. (2)

   Thus each regional market included up to five different types of firm:

   * The Incumbents within their home regions

   * British Gas, entrant into electricity, but incumbent and previous monopoly gas supplier in each region. (3)

   * Majorsaway--the four major incumbents from other regions

   * Mini-Majorsaway--(10) other original incumbents, acquired by the Majorsaway during the first half of the period

   * Independents--(up to 5) suppliers with no region of previous incumbency.

   All suppliers (apart from one Independent) were also active in the gas market, which had been liberalised two years before the electricity market. Increasingly, such suppliers participated in mixed bundling by offering a 'dual-fuel' discount to consumers who bought both fuels from them.

   As discussed later in the paper, there were two potential sources of asymmetry between the suppliers. First, the Incumbents, Majorsaway and British Gas were all integrated upstream into generation, unlike the others (with one exception). Secondly, the Incumbents may have been favoured by consumers because of brand loyalty or the costs of changing suppliers. Relative to other entrants, British Gas would have been less disadvantaged by this, because of both consumer familiarity within the gas market and the possibility of bundling gas and electricity (Hviid and Waddams Price, 2012).

   Electricity transmission is provided by the National Grid (a regulated privatized monopolist) and there is a monopoly distributor in each region (sometimes one of the Majors) which is required to serve all retailers on identical and regulated terms.

   Data on market shares by firm and region over time are currently unavailable. However, it is known that during the seven years after liberalisation, nearly half of consumers switched away from their regional electricity incumbents. By 2005, the average market share of original incumbents in their home region was just over 50%, with British Gas accounting for about 23%, and the Majorsaway (together) for another 23%; Independents had around 1% of the market (Ofgem 2006, p. 18). British Gas derived much of its success from widespread switching to dual-fuel tariffs. By 2004, 80% of switching in the energy market was to dual-fuel deals (Ofgem, 2004, p. 78).

3. THEORETICAL LITERATURE

   The standard results of nonlinear pricing for monopoly are well established (e.g. Mussa and Rosen 1978, Maskin and Riley 1984). If consumers possess private information about their tastes, with higher types having a higher marginal utility over all units, the monopolist's optimal price-quantity schedule is concave such that higher types are offered a lower average price per unit. As illustrated in Figure 1, this can be approximated by offering a menu of two-part tariffs, with decreasing marginal prices, p, and increasing fixed fees, F, such that higher types optimally select a tariff with a lower marginal price and a higher fixed fee. Intuitively, marginal prices are distorted above marginal cost, for all but the highest type, in order to extract larger rents from higher types by discouraging them from selecting a tariff intended for a lower type.

   The literature on oligopolistic nonlinear pricing is less well established (see reviews by Armstrong 2006 and Stole 2007). In a one-stop setting, where consumers can buy from at most one supplier, the related papers by Armstrong and Vickers (AV, 2001) and Rochet and Stole (RS, 2002) are of particular interest. After detailing their key results below, we then discuss the applicability of each key assumption to the British electricity market.

   In their...