Cost Savings from Generation and Distribution with an Application to Italian Electric Utilities

Abstract

In the last decade a new regulatory framework for electric utilities, aiming at a gradual liberalization of the sector, has been set in Europe. The promotion of competition among generators implies the need to separate power generation from downstream transmission and distribution activities. However, if cost savings can be reached by operating at different stages, vertical separation is accompanied with a lost of efficiency. This paper investigates the latter issue by testing for the presence of economies from vertical integration on a sample of 25 Italian local electric utilities, observed in the years 1994-2000. The estimates of a Composite Cost Function model show for the average firm (300 million Kwhs of generation and 600 million Kwhs of distribution) that both multi-stage economies of scale and vertical economies are present. These measures increase with firm size, with the cost savings of vertical integration rising from 3% up to 40% for large operators. Furthermore, fully integrated utilities, for which the ratio of generated over distributed electricity is unity, enjoy higher cost synergies with respect to firms characterized by lower own-generation ratios. Overall, our findings suggest caution in pursuing a systematic breakdown of vertically integrated electric utilities.

Keywords: Electric Utilities, Liberalization, Vertical Integration, Composite Cost Function

JEL Classification: L11, L50, L94