Structural reform of Japanese electric power industry: Separation between generation and transmission & distribution

This study examines the cost structure of Japanese electric power industry to investigate whether a structural reform on the industry really enhances a cost-saving benefit to consumers. A composite cost function model, using a panel data set, is used for this study. The data set consists of nine electric power companies from 1990 to 2008. Based upon the estimation results, this study examines whether economies of scale and vertical economies exist in the industry. Then, this study conducts a cost subadditivity test that is a necessary condition of natural monopoly. The empirical results indicate that the electric power firms exhibit the status of economies of scale in their transmissions and distributions and the operation as a whole. However, they do not exhibit economies of scale in their generations. Thus, the transmission operation, by integration, in a large area can improve its economic efficiency. Furthermore, the industry should introduce more competition in both generation and wholesale power markets where more firms can participate in their power trades. This study also empirically confirms that vertical economies have existed in the industry. Moreover, this study confirms that all the estimates in the cost subadditivity test satisfy the necessary condition of natural monopoly, where each estimate indicates cost saving in cost subadditivity. The test does not guarantee a sufficient condition of natural monopoly. However, it clearly indicates that the functional separation between generation and transmission will increase total production cost in the industry. The complete separation may result in a net loss of economic efficiency if a competition benefit does not exceed an expected economic loss. Consequently, this study suggests that the industrial structure of future Japanese electric power industry should be evaluated from not only an expected benefit by introducing competition but also an unbundling cost that occurs with a loss of vertical integration.