Vertical integration of electricity distribution network operator and electricity supplier is a key issue in European energy markets, in particular since the European Commission (EC) has initiated a sector inquiry in 2005. The EC argues that vertical separation of electricity networks from other activities (such as production and retail) increases consumer surplus, while opponents argue that vertical integration enables cost savings due to economies of scope. The European Competition Commission too indicates the disadvantage of vertical integration in energy markets for retail customers caused by potential discrimination of competitors. Aiming at preventing non-price discrimination the EC suggests alternative regulatory approaches to overcome the challenge of vertical integration. Legal unbundling, as an intermediate approach between ownership unbundling and vertical integration, describes a particular type of separation. In this case, the regulation requires legal separation of a grid unit from the retail/production and the operation of the grid by independent management.

In a theoretical model we show that vertically integrated incumbents in the electricity market might have an incentive to favor their own downstream unit over competitors. We distinguish between demand decreasing and cost increasing non-price discrimination. Delaying supplierswitching or withholding important information from competitors are examples for such types of non-price discrimination. This discriminatory behavior might affect the retail prices. Therefore, consumers might be worse off if the distribution network operator and the downstream retail incumbent remain vertically integrated. We further consider the effects that arise from introducing legal unbundling as already implemented in several European Countries. In line with other studies, the results show the legal unbundling regime to be favorable if it works perfectly, i.e. can indeed prevent non-price discrimination.

To test our hypotheses derived from the theoretical model we employ cross-sectional data for geographically separated submarkets for household customers in Germany, each served by one distribution network operator, one downstream retail incumbent and a number of small energy providers. As the vertical structure is heterogeneous across the 850 German electricity submarkets for residential customers (there exist legally unbundled, vertically integrated or fully separated firms), we use firm level data to analyze the effects of different vertical structures and regulation schemes on retail electricity prices. We find significantly higher prices in markets with vertically integrated firms compared to markets with fully separated firms. This finding could indicate non-price discrimination. Furthermore, we find no evidence that legal unbundling eliminates the incentives for non-price discrimination because the prices do not differ from prices in markets under vertical integration. Therefore, we suggest implementing stricter rules for sufficient legal unbundling to prevent potential discrimination against competitors.