Is bigger better? Mergers in electricity distribution
A new paper published recently in New Zealand Economic Papers by ex-TDBer Dr. Tom Stannard (now at Otago University’s Accountancy and Finance Faculty) and TDB Director Phil Barry explores the case for economies of scale from mergers in the electricity distribution sector. The paper analyses new data on electricity distribution businesses (EDBs) between 2013 and 2022.
Industries often see increases in productive efficiency when smaller companies merge into larger ones, with average per-unit costs reducing while output levels are maintained. An individual firm can increase its productive efficiency by spreading its fixed costs across more customers, thereby reducing its average per-unit cost. Firms achieve gains from scale if an industry has a downward-sloping average cost curve as output increases. Conversely, if the industry has an upward-sloping average cost curve, firms may experience diseconomies of scale.
EDBs operate as natural monopolies in their respective regions and face a downward sloping average cost curve. However, as the paper illustrates, this doesn’t necessarily mean that EDBs can achieve economies of scale when merging with natural monopolies in other regions.
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The paper examines the relationship between changes in unit cost and the size of New Zealand EDBs between 2013 and 2022, testing in particular the explanatory effect of customer density to determine to what extent reduced unit costs of an EDB can be attributed to increases in size after controlling for differences in customer density over the same period.
The size of an EDB was measured in three different ways: energy delivered, customer connections, and maximum demand. Customer density was measured by size divided by total network length (km). The findings were consistent across each set of measurements.
The paper found that increasing scale does not guarantee reductions in unit costs. For regional monopoly providers like EDBs, which own, operate and maintain large, capital-intensive infrastructure, simply increasing geographical scale without increasing population density is unlikely to lead to a major reduction in unit costs and may even lead to an increase in unit costs if diseconomies of scale dominate. In contrast, for every 1% increase in customer density, EDBs experienced a 0.45% reduction in unit costs. As a result, the paper questions the extent to which physically separate networks like EDBs can truly realise economies of scale through consolidation.
