Vertical Integration vs Vertical Separation in an Imperfectly Competitive Industry, such as Electricity, with Retail, Wholesale and Forward Markets

In an imperfectly competitive industry for a homogeneous good like electricity - with forward wholesale and retail markets - should upstream firms (generators) be vertically integrated with or separated from downstream firms (retailers)? Left to their own devices will firms integrate or separate and how does this contribute to welfare? Vertical integration is often viewed by competition authorities regulators and policy-makers with suspicion but are these suspicions misplaced? We address these questions by developing a static and deterministic multi-stage game with oligopolies in both generation and retailing and endogenous choice by generators over the degree of vertical integration. Firms simultaneously compete in quantities in successive forward wholesale and retail markets with retailers able to purchase forward energy from generators. We find that total surplus consumer surplus and other welfare measures are unambiguously better under higher levels of vertical integration. According to many measures we find that "four is enough" i.e. that once a sector has four generators there are diminishing returns in terms of welfare from adding more generators. Moreover full integration is akin to "synthetic" generation - equivalent in welfare terms to adding an additional generator in an otherwise separated sector. Our analysis supports earlier research that shows integrated firms pursue a "raising rivals' costs" strategy - buying wholesale energy to increase the input cost of separated downstream rivals. However by adding forward contracting we also find that separated retailers pursue a counterveiling "over-buy and recycle" strategy - buying more energy forward than they need to meet their retail supply commitments and selling their surplus energy on the wholesale market. This not only protects them against the integrated firms' strategy but in the case of duopoly generation at least ensures that full integration is the generators' only equilibrium choice.