Consumer inertia and switching costs in the Norwegian electricity market

Abstract

In this thesis we aim to investigate the degree of consumer inertia and estimate the switching costs in the Norwegian electricity market. We utilize two separate models to estimate the implicit switching costs embedded in the switching behavior of the consumers. Both models enable us to extract meaningful information about both the significance and magnitude of switching costs from highly aggregated market share data. Our dataset contains a panel of monthly observations of prices and market shares of the five largest retailers on each power distribution grid. Each distribution grid can be said to represent a separate market, where both nationwide and local retailers compete for the consumers located within the geographical area of that grid. Due to this type of market structure, we find a large variation in the distribution of market shares across markets. Some markets are close to monopolies, as the largest retailer covers close to the whole market, while other markets have a more even distribution of market shares, and thus stronger competition. Moreover, we find that variable price contracts are systematically higher priced, and have higher markups, than spot price contracts. This leads to our next finding of significant gains from switching, both between retailers and, especially, from variable to spot price contracts. Despite these potential gains from switching, we find evidence for consumer inertia in the Norwegian electricity market. In particular, we obtain point estimates of switching costs of 19.28 øre/kWh and 16.20 øre/kWh from our two models. In annual terms, this means that Norwegian consumers are on average willing to pay a premium of about 2,600 to 3,100 NOK rather than switching electricity supplier monthly. The estimated switching costs account for as much as 50 % to 60 % of the average yearly electricity bill for the consumers. Additionally, we find evidence that retailers exploit the inertia of their customers, by utilizing "bargain-then-ripoff" pricing strategies. That is, retailers use penetration pricing, introductory offers and price wars to obtain as many new customers as possible, while they charge higher prices to already locked-in customers. Consequently, the existence of switching costs in the Norwegian electricity market leads to weakened competition and inefficient markets. Keywords – Industrial organization, switching costs, consumer inertia, customer lock-in