The share price of the Indian Energy Exchange (IEX) fell 20 percent in the previous week and is down approximately 60 percent from its peak in December 2021.
Once regarded as a prominent beneficiary of the rising share of exchanges in India’s energy trading volumes, IEX faced substantial challenges last week following reports suggesting an imminent regulatory change that could potentially terminate the company's virtual monopoly.
In today’s article, we delve into the phenomenon of the network effect and its role in generating substantial value for shareholders, as observed in the cases of Microsoft and Facebook. We also explore how the network effect has enabled technically inferior products, such as the PlayStation 2, to maintain their position as market leaders over competitors like the Xbox.
We also discuss how the network effect has the ability to shift the balance of power, as exemplified by the competition between Apple Music and the "Big Four" record labels. However, the existence of regulatory authorities possessing overriding powers can significantly disrupt the network effect's influence and impact.
In the field of economics, the concept of a "network effect" refers to a phenomenon wherein the value or usefulness that a consumer obtains from a particular good or service is contingent upon the number of other individuals utilising compatible products.
This effect is sometimes referred to as Metcalfe's Law, named after Bob Metcalfe, the innovator behind the development of the Ethernet networking standard. During the early stages of the dot-com era, Metcalfe expressed the notion in an article published in InfoWorld magazine, asserting that the value of a network is directly proportional to the square of its user base.
Also Read: IEX says market coupling will kill innovation, move akin to clubbing Ola, Uber
Most products are not subject to the network effects – we probably do not care if someone wears the same socks or buys the same trash bags as us. But in scenarios where network effects are present, they constitute one of the most crucial factors in determining the choice between different offerings. The value derived from network effects can be attributed to three key aspects: (a) exchange, (b) staying power, and (c) complementary benefits.
Exchange: Take social media for example. A single user on Facebook or Twitter does not derive significant enjoyment or utility from the platform. Similarly, the first owner of a fax machine would find a limited practical use for it. However, as each additional individual becomes part of the network, whether as a friend, follower, or fax user, the overall network gains in value and utility. The increasing number of participants enhances the usefulness and functionality of the network.
Staying power: Users are generally reluctant to invest in a product or service that may not endure over time, particularly when there is a lack of user adoption or the company providing it is facing financial instability.
Networks with a larger user base imply a greater degree of staying power. An illustrative example can be observed in the computer market during the early 2000s, where customers were presented with the choice between Windows, Mac OS, and Linux as operating systems.
Despite the presence of some technical issues, customers predominantly opted for Windows due to their confidence in its ability to sustain and thrive in the long run. The perception of Windows' wide user base and market dominance influenced their decision.
Complementary benefits are the products and services that add additional value to the network. In early stages, a wide range of resources emerge, such as books on eBay auctions or MS Excel tutorials or the plethora of iPod speaker systems (including unconventional options like the iCarta toilet paper holder with iPod playback). These complementary offerings create a self-fulfilling market, enhancing the network's power.
The network effect is so powerful, in part, owing to its tendency to operate in a winner-takes-all fashion, resulting in the establishment of effective monopolies.
As larger networks offer greater value, they are able to command higher prices from customers (Microsoft's pricing of its operating system or Facebook's ad slots). Moreover, network effects grant substantial relative pricing power, enabling companies like Apple, which held a 75 percent market share in digital music sales, to dictate terms to major record labels.
Network effects also serve as a deterrent to competition even when a technically superior product exists (PlayStation 2's dominance in the video- gaming console market over Xbox despite critical reviews favouring the latter).
Undoubtedly, network effects exert a formidable influence. IEX, established in 2008 as an electronic system-based power trading exchange, possessed the potential to thrive due to the network effect.
With a robust ecosystem comprising more than 7,500 registered participants and over 600 generators, IEX has achieved an impressive market share of over 99 percent in both the day ahead and real-time market segments. Consequently, it is unsurprising that IEX has reported a remarkable 30 percent CAGR in trading volumes since its inception.
IEX’s narrative was simple: Currently, a substantial portion (87 percent) of India's power consumption, is sold through long-term PPAs, while only 7 percent is traded through power exchanges.
Given the existing challenges in India's power sector, characterised by loss-making distribution businesses struggling to secure additional PPAs, it is anticipated that the share of power sales through exchanges will increase to align with global standards. For instance, France records a 15 percent share, the UK demonstrates a 47 percent share, and the Nord Pool achieves an impressive 91 percent share.
Leveraging its early-mover advantage and formidable offerings, IEX is poised to maintain its dominant market position, effectively fending off competition from emerging challengers such as PXIL and HPX. Consequently, IEX can anticipate a near-monopolistic market share, facilitating sustained growth in transaction fees, admission fees, and annual fees. This, in turn, is likely to generate superior profit growth for longer.
Also Read: Market coupling casts a shadow on IEX. What should investors do?
The regulators had a different perspective. On July 18, 2020, CERC proposed an enabling provision in the Draft Power Market Regulation to introduce "market coupling" among power exchanges. This entails the establishment of a Market Coupling Operator (MCO) responsible for collecting and matching bids from different power exchanges to determine the price of the day-ahead and real-time market.
The regulator expressed concerns regarding the suboptimal transmission corridor among power exchanges due to the uneven market share distribution. Consequently, they believed that the overall economic surplus was not being maximszed. Furthermore, the potential introduction of financial derivatives (currently being examined by SEBI) would require a uniform price discovery mechanism.
While the regulation regarding market coupling among power exchanges remains in the draft stage, recent reports suggest that the power ministry has urged the CERC to expedite the finalization of this regulation.
If implemented, IEX not only risks losing its monopoly status but may also need to make compromises on the transaction fees it charges to retain customers. However, despite the market's reaction to the news, the regulation has not yet been finalised. There will be a process of inviting consultations and further deliberations before the law reaches its ultimate form.
Nevertheless, it is crucial to recognise that in regulated sectors, the advantages derived from network effects are challenging to attain. The painstaking efforts and innovation invested over the years can be swiftly undone by the implementation of regulatory changes. As investors, it is incumbent upon us to consider this aspect when formulating valuation models for businesses operating in such regulated environments.
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