Structural separation versus vertical integration: Lessons for telecommunications from electricity reforms

Structural separation between network and retail functions is increasingly being mandated in the telecommunications sector to countervail the market power of incumbent operators. Experience of separation in the electricity sector offers insights for policy-makers considering telecommunications reforms. Despite apparent competitive benefits, the costs of contracting increase markedly when short-term focused electricity retail operations are separated from longer-term generation infrastructure investments (which require large up-front fixed and sunk cost components). The combination of mismatches in investment horizons, entry barriers, and risk preference and information asymmetries between generators and retailers leads to thin contract markets, increased hold-up risk, perverse wholesale risk management incentives, and bankruptcies. Direct parallels in the telecommunications sector indicate exposure to similar complications, intensifying many of the contractual risks arising from regulated access arrangements. Thus, as in electricity, competition between vertically integrated telecommunications providers would likely induce more efficient and sustainable investment and competition than would separation.