House of Commons - Trade and Industry

Select Committee on Trade and Industry Second Report

CHAPTER THREE: COSTS AND BENEFITS OF LIBERALISATION

The Costs of Liberalisation

17. Each of the 14 PESs (the 12 RECs in England and Wales and ScottishPower and Scottish Hydro-Electric) have been required, by existing licence conditions, to develop and implement business systems and services to enable supply competition to take place. As customers switch between suppliers, these systems and services will be used by suppliers other than the PES which developed them. Current OFFER proposals for price restraints in the post 1998 market provide for costs incurred by PESs in the development of these systems to be passed on, up to a fixed amount, to other suppliers who use their systems on a non-discriminatory basis (including in relation to the PES itself as a supplier).[21] Suppliers will, in turn, be able to pass these costs on to customers.

18. The proposed amount that each PES will be able to recover is roughly based on the number of customers in its current franchise (see Table I).

Table I: Proposed Competition Service Charge Restrictions (at 1995 prices)

	Franchise Sales GWh	Franchise Customers	Proposed Revenue per year (£m)	Revenue over 5 years (£m)
Eastern	18025	3089600	3.0	15.0
East Midlands	12534	2254400	2.4	12.0
London	11087	1976600	2.3	11.5
Manweb	7488	1350000	1.9	9.5
Midlands	12569	2225000	2.4	12.0
NORWEB	11721	2183300	2.4	12.0
Northern	7103	1448100	1.9	9.5
SEEBOARD	11622	1985300	2.3	11.5
Southern	15333	2603200	2.7	13.5
SWALEC	4753	948300	1.6	8.0
South Western	8096	1307600	1.9	9.5
Yorkshire	10148	2027000	2.2	11.0
ScottishPower	11980	1788300	2.2	11.0
Hydro-Electric	5315	614600	1.5	7.5
Total	147774	25801300	30.7	153.5

Source: OFFER, The Competitive Market from 1998: Price Restraints, September 1996, p. 49.

In addition to the development costs that PESs will be able to recover, there is also provision for the recovery of a further £10 million per year for 5 years against operating costs of all the PESs. Therefore, OFFER's current proposals envisage that PESs will be able to recover some £210 million over 5 years.[22] The Pool, which also has substantial development responsibilities, will be permitted to recover incurred costs up to £50 million.[23]

19. Several witnesses suggested that the £210 million proposed by the regulator is not sufficient to meet the actual costs they will incur. East Midlands Electricity told us in November 1996 that the "high costs ... associated with full competition are generally understated ... we suspect that the total real cost will exceed £500 million".[24] More recently, the Chief Executive of East Midlands Electricity has told us that "based on our own estimates, I would be surprised if the total industry costs over a five year period did not exceed £1 billion".[25] London Electricity said that "on our most optimistic forecasts, ... investment is substantially greater than we will be able to recoup through OFFER's presently proposed cost recovery arrangements".[26] The Electricity Association are concerned that their members "are having to finance beyond £210 million".[27] Such concerns have also been mirrored by industry commentators and the media. Media reports have suggested that unrecoverable costs, those in addition to the £210 million, could reach £500 million.[28] In February this year, Power UK estimated that development costs for PESs' systems would be around £486m with annual operating costs "somewhere around the £40m mark".[29]

20. In March this year we asked all the PESs to provide us with their latest estimates of the costs they would incur in developing and operating competition services for a five year period. All but NORWEB responded. Not one of those who responded expected to able to deliver and operate their systems within the recoverable cost limits proposed by the DGES.[30]

21. Hydro-Electric pointed out that costs for the Scottish PESs were likely to be higher on average than those for PESs in England and Wales, reflecting the facts that their costs, and those of ScottishPower, also included the development of Scottish Settlement and that there are fewer customers over whom to spread the fixed costs of systems development.[31]

22. The DGES was aware that several companies were dissatisfied with the proposed limits for cost recovery, but said that he could not accept at face value claims by companies that their costs were higher than he appreciated and that less stringent controls were needed. He also stressed that it was important to distinguish between the costs that PESs incurred as a direct result of providing competition services and those that they might have incurred in any case to update or improve customer services and information systems - a point accepted by the Electricity Association.[32] Nevertheless, the DGES will be reviewing the proposed recovery limits and has asked PESs to provide him with further information.[33]

23. We share the belief of the Electricity Association that "the cost of facilitating competition ... should be properly acknowledged and properly recovered across all players in the market".[34] Nevertheless, we are equally convinced that the DGES should protect consumers against suppliers passing on inappropriate costs. We welcome the DGES's intention to keep the permitted levels of recoverable costs under very close scrutiny.[35] We recommend that the DGES should propose higher limits for cost recovery only if convincing evidence is provided that higher costs have been incurred as a direct consequence of the development and operation of competition services, and that such costs are reasonable.

The Benefits to Consumers of Liberalisation

24. The DGES told us he expected prices to consumers with a peak demand under 100 kW to fall "significantly" in the post 1998 competitive market.[36] Most witnesses agreed that prices would fall to some degree. The Electricity Association expects to see "keener prices";[37] Enron told us that the "potential benefits of competitive markets to consumers are real and substantial"[38] and, similarly, the ECCCG and London Electricity predicted lower prices.[39]

25. Several witnesses, including OFFER, cited the experience of competition in the over 100 kW market, where there have been "significant reductions in prices, more innovative tariff design and new customer services" as evidence that liberalisation in the under 100 kW market would deliver similar benefits to consumers currently covered by PESs' franchises.[40] As we commented in 1995, we do not believe that such comparison is relevant, as the 1994 exercise involved "larger customers and much of the fall in prices is because such consumers ceased to pay prices reflecting the higher cost of British coal".[41]

26. Other witnesses were more sceptical. The Institution of Electrical Engineers believed that "there is little scope for REC suppliers to offer worthwhile electricity price reductions to customers".[42] The National Consumer Council (NCC) argued that "supply to the consumer is inherently monopolistic" and that, while competition may deliver benefits to the larger consumers, "it may prove to be unnecessarily complicated and could be socially divisive for domestic users".[43] They added that "the case for competition in electricity ... supply to domestic customers may have been overstated".[44] The Consumers' Association agreed, stating that "it is not clear that competition in supply will be in the interest of domestic users".[45]

The scope for price reductions

27. Such conflicting opinions over the likely benefits of liberalisation for low-volume consumers led us to question where such benefits, and particularly price reductions, might come from. Consumers pay bills which reflect various aspects of the costs involved in producing and delivering electricity - generation, transmission, distribution, supply - and the Non-Fossil Fuel Levy. Transmission and distribution will continue to be monopolistic operations, and therefore subject to price controls, for the foreseeable future. However, the DGES told us that there was scope for price reductions as a result of liberalisation, from both more efficient supply operations and more economic purchasing of electricity by suppliers from generators.[46]

Table II: Cost Breakdown of Franchise Customers' Electricity Bills, 1995/96

Area of Cost Reflected in Customers' Bills Percentage of Total Bill

(Scotland) Percentage of Total Bill

(England and Wales)

Supply Costs 6% 6%

Generation 65% 52%

Transmission 4% 4%

Distribution 25% 29%

Non-Fossil Fuel Levy¹ 0.1% 9%

Total 100% 100%

Source: OFFER, The Competitive Electricity Market from 1998: Price Restraints, September 1996.

Note: ¹ The Non-Fossil Fuel Levy in England and Wales has subsequently been reduced to 3.7% and will be further reduced to 2.2% on 1st April 1997. In Scotland it has risen to 0.5% and will rise further to 0.7% on 1st April 1997.

28. Supply costs (metering, billing, dealing with customer complaints etc) currently represent around 6% of low-volume consumers' final bills (see Table II).[47] This amounts to between £15 and £27 of domestic consumers' average annual electricity bills of roughly £270. The ECCCG suggested that supply costs would fall as "suppliers sharpen their practices and refine their services",[48] but other witnesses pointed out that profit margins on supply operations are already small.[49] "Operating profits for the REC supply businesses are in the range of £9m to £30 million, with a margin on turnover of 1%-2.5%. Supply business profits of the Scottish PESs are lower".[50] Furthermore, as the ECCCG accepted, even a substantial reduction in supply costs would have only a limited impact for low-volume consumers as supply represents such a small proportion of their final electricity bill.

29. Generation currently accounts for some 50% of the average annual bill to low-volume consumers in England and Wales and some 65% in Scotland. RECs purchase the majority of their electricity by contract. There are two ways in which the more economic purchasing of electricity by suppliers from generators could result in price reductions. The first is through the application of market disciplines to the purchasing contracts of RECs. However, Professor Littlechild told us that a survey of purchasing costs of generation across all the RECs had identified a "remarkably small" difference of "not more than a per cent or two" between the companies.[51] Nevertheless, he added that differences could increase as RECs will have to be "even more attuned to the need to purchase competitively" in the liberalised market.[52] Other witnesses, such as East Midlands Electricity and the ECCCG, agreed that it was economic purchasing that provided the greatest scope for price reductions.[53]

30. The second factor which could result in lower prices for consumers is a reduction in the `contract premium' that RECs currently pay above Pool prices.[54] The DGES told us this contract premium would be reduced when the coal-backed contracts, which RECs were required to sign by the Government, come to an end in 1998. This would leave the RECs free to sign contracts "very much more closely related to Pool prices". The DGES argued that, even though it was unlikely that the contract premium would disappear completely, a reduction to, for instance, 5% would present significant scope for price reductions to low-volume consumers.[55] However, we are not convinced that it would be right to attribute such savings to liberalisation directly. The coal-backed contracts will expire in 1998 whether the low-volume supply market is liberalised or not. Furthermore, the end of the coal-backed contracts will effect RECs broadly equally and therefore will not deliver any significant competitive advantage. Nevertheless, liberalisation may serve to ensure that any savings resulting from a reduction in the contract premium are passed on to consumers.

Other potential benefits to consumers

31. It is widely expected that competition will also lead to new or improved customer services as suppliers attempt to distinguish themselves in a market where their core product is identical to that provided by competitors. Lord Fraser of Carmyllie, the Minister for Energy, told us that liberalisation would offer the "potential for a really quite extraordinary range of innovations".[56] The Electricity Association argued that "new services, new ideas [and] new players ... in a broader sense would be in the consumers' interests".[57] London Electricity told us that "customers will be able to choose new tariff and pricing structures, differentiated services and possibly combined supply and energy efficiency packages" and that "product innovation may result in fresh approaches to billing and payment, and the development of new methods of metering and data collection".[58] We accept that the development of such energy services, beyond simple supply, is possible but note that is not supported by early experience of the gas trials in the South West where competition has occurred almost exclusively on the basis of price.[59]