Supplementary evidence submitted by Energywatch
WHY THE BRITISH MARKETS IN GAS AND ELECTRICITY
REQUIRE A COMPETITION INVESTIGATION
AN ENERGYWATCH DISCUSSION PAPER
1. INTRODUCTION
1.1 Purpose
Exactly a year ago energywatch set out some
thoughts in a discussion paper How energy markets are failing
consumers.[143]
The paper followed analysis of aspects of the domestic energy
markets in Great Britain (GB) that we thought were acting against
the interests of consumers. At that time the concerns centred
mainly on whether markets were competitive enough for the fall
in wholesale prices being seen then to be passed through to consumers
and so alleviate rising fuel poverty and declining industrial
competitiveness.
A dominating theme of the paper was the energywatch
viewwhich we continue to holdthat many of the problems
acknowledged by regulators with regard to the development of competitive
gas and electricity markets on mainland Europe are shared by our
domestic markets.
Energywatch is pleased that the earlier paper
stimulated discussion that has led to an increase in political
awareness of the dysfunctionality of energy markets and the problems
faced by British consumers.
Now 12 months on the position the industry finds
itself in has changed, and the concerns are different against
a background of prices that are once again rising. Most major
suppliers, in contrast to last year when price reductions were
slow to be announced and slower to be implemented, have moved
extremely quickly since the turn of 2008 to levy and implement
increases in their household prices. But although the circumstances
and symptoms differ, the underlying malady is the sameour
energy markets are not properly competitive and are continuing
to fail consumers.
Energywatch believes British policy makers and
regulators urgently need to focus on these deficiencies. We welcome
the decision of the Business & Enterprise Select Committee
in February 2008 to investigate key aspects of market design and
industry competitiveness. Ofgem has also announced that it is
to investigate the retail markets under its Enterprise Act 2002
powers, although disappointingly it has already said in advance
of its investigation it does not consider there to be evidence
of abuse.
1.2 Structure
This second discussion paper addresses the issue
of how the markets are working in 2008. It starts by setting out
in chapter 2 a summary of pricing developments in the sector over
the past five years or so, a period which has seen vigorous cycling
of fuel and energy prices, and it looks at the effect on the bills
paid by both household and business consumers. It then sets out
the key arguments in support of Energywatch's case that current
markets for electricity and gas embody now (as they did a year
ago):
"a feature or combination of features of
a market in the UK for goods or services [which] is, or appears
to be, significantly harming the interests of consumers' (Enterprise
Act 2002)".
The basis for making a Competition Commission
referral (Section 131/132 of the 2002 Act) is where the enterprise
secretary or sectoral regulator (in this case the Gas and Electricity
Markets Authority, usually referred to as Ofgem) has "reasonable
grounds for suspecting any feature or combination of features
prevents, restricts or distorts competition". The commission
then determines whether a feature or a combination of features,
structural or conduct, of the GB energy markets has any adverse
effects on competition (AEC) and decide whether action can be
taken to address the AEC or any detrimental effect on consumers.
Section 134(5) explains that detrimental effect on consumers means
higher price, lower quality, less choice or less innovation.
The paper is then structured around the main
issues raised in the Business & Enterprise Select Committee's
terms of reference but reordered and grouped. They are:
whether there is effective competition
in the wholesale markets for gas and electricity (chapter 3);
the relationship between wholesale
and retail markets and the implications of growing consolidation
in the energy market (chapter 4);
whether the current market structure
encourages effective competition in the retail markets for gas
and electricity (chapter 5);
the effectiveness of regulatory oversight
undertaken by Ofgem (chapter 6).[144]
The paper concludes with recommendations, set
out in chapter 7, addressing:
the scope of issues we think the
committee should address and require referral to the Competition
Commission; and
energywatch's options and proposals
for rectification of the deficiencies we have identified.
energywatch believes there is a clear evidential
basis to substantiate allegations that the gas and electricity
markets are not functioning as intended and that consumers are
suffering as a consequence. We maintain that a referral to the
Competition Commission is necessary. We urge the select committee
to endorse this course of action and invite the enterprise secretary
or the energy regulator to initiate the process urgently.
2. CONTEXT
This chapter considers developments in the gas
and electricity markets that have impacted on consumer prices.
It summarises the price changes that have occurred and then looks
at the impact on bills in the different retail markets.
2.1 A volatile market
For over 15 years, British policy makers, regulators
and energy companies have maintained that British energy marketsthe
self-proclaimed most competitive energy markets in Europehave
delivered significant benefits for consumers. And for a while
price reductions, entry by new participants and product and service
innovation did seem to bear out this message, especially given
the parlous state of competition in many mainland markets.
But suppliers argued for a while that domestic
consumers, who did not benefit from a wholesale electricity price
collapse in 2001-03, were lucky because the full effects of a
traded market that saw a first wave of large price increases and
record high prices between 2004-06 were not passed onto them.
This argument has been extended by them to explain why price reductions
when they did occur from early 2007 were delayed and, when price
cuts were introduced, why they did not fully reflect the magnitude
of the reductions in wholesale prices that occurred.
The large suppliers who dominate markets to
domestic consumers continue to imply that they are fully or significantly
exposed to these wholesale prices, despite their ownership of
production assets and the existence of extensive legacy fuel supply
arrangements that have allowed them to avoid at least some of
the higher costs being seen in traded markets. But these higher
costs are again referenced as the main justification for a second
wave of double digit price increases seen by consumers since the
turn of the year.
Figure 2.1
ANNUAL GAS, ELECTRICITY AND OIL PRICES, 2002-08

Source: Heren
But one constant is that these large companies
making supply to retail markets in Britain have virtually all
recorded growing profits through the period whether wholesale
prices have been high or low. Since 2005 they have also been the
beneficiaries of "free" carbon allowances, despite the
fact that the nominal cost of these allowances seems to have been
passed through in full to consumer prices, creating windfalls
and record profits, and even the regulator has called for another
windfall tax following an earlier one that was levied by government
in 1998.
energywatch acknowledges that wholesale gas
and electricity markets have undergone profound change since the
turn of the decade as global commodity markets have cycled aggressively.
The price path of the key annual contracts is shown at Figure
2.1, together with the corresponding Brent oil price. 2006 was
a particularly turbulent year, with then record oil prices compounded
by local concerns over security of supply.
2.2 Impact on domestic consumers
Reflecting this price volatility the year 2006
saw 14 major retail price increases levied by the largest suppliers,
usually termed the Big Six,[145]
who supply all but a handful of the 47 million household electricity
and gas accounts in Britain. Subsequently in response to rapidly
falling wholesale prices they belatedly proposed general price
cuts in 2006-07, but many consumers had to wait until winter was
over to get them.
The reductions introduced during 2007 offered
only a brief respite. Since the beginning of this year all of
the Big Six have reversed out these reductions, and they have
increased their prices significantly. RWE npower led the way.
The companies all reference rebounding wholesale prices but also
new and rising environmental costs as the main reasons for the
latest increases. In the case of electricity these increases have
more than off-set the reductions made last year.
The price changes to domestic consumers since
2004 are shown at Appendix 1. The changes that have occurred this
year so far are shown at Table 2.1.
Table 2.1
HOUSEHOLD PRICE CHANGES LEVIED BY BIG SIX
SINCE 1 JANUARY 2008
(%) | Electricity
| Gas | Effective date
|
RWE Npower | 12.7 | 17.2
| 04 Jan 2008 |
EDF Energy | 7.9 | 12.9
| 18 Jan 2008 |
British Gas | 15.0 | 15.0
| 18 Jan 2008 |
Scottish Power | 14.0 | 15.0
| 02 Feb 2008 |
E.ON UK | 9.7 | 15.0
| 08 Feb 2008 |
SSE | 14.2 | 15.8
| 01 Apr 2008 |
Source: Company media statements
These increases have led to a combined average household
bill now exceeding £1,000, as shown at Table 2.2, with combined
increases in excess of 55% over the past three years based on
the latest Energywatch data. But there are indications from analysts
that suppliers have been earning increasing returns on their supply
businesses. Under the old price controls administered by Ofgem
up until 2002 they were allowed a 1.5% margin, and in the early
days after these controls were lifted returns rose to around 4.5%
reflected perceptions of higher risk.[146]
Since then, while some suppliers have claimed occasionally negative
margins, at times earnings have been as much as 30% on their retail
businesses.[147] The
current consensus is that even now margins for those with the
lowest prices could be running at over 6%.
Table 2.2
AVERAGE ANNUAL DOMESTIC FUEL BILLS 2005-08STANDARD
CREDIT SUPPLY
| 2005 | 2006
| 2007 | 2008
(March)
| Change |
Gas | £386 | £473
| £552 | £632 | 64%
|
Electricity | £285 | £338
| £383 | £405 | 42%
|
Total | £671 | £811
| £935 | £1,037 |
55% |
Source: Data for 2005 to 2007 is from Berr. That for March
2008 is from Energywatch. Both sources are based on a medium user
consuming each year 3.3MWh of electricity and 20.5MWh of gas.
These recent trends are summarised by company at Tables 2:3
and 2:4[148] for electricity
and gas respectively.
Table 2.3
HOUSEHOLD ELECTRICITY PRICE CHANGES LEVIED BY BIG SIX
(ANNUALISED)
Company | 2005
| 2006 | 2007
| 2008 | Period
|
| Changes | Effect
(%)
| Changes | Effect
(%)
| Changes | Effect
(%)
| Changes | Effect
(%)
| Changes | Effect
(%)
|
British Gas | 1 | 9.4
| 2 | 33.5 | 2 |
-16.3 | 1 | 15.0 |
6 | 40.5 |
E.ON UK | 1 | 11.9
| 2 | 29.9 | 1 |
-5.0 | 1 | 9.7 |
5 | 51.5 |
EDF Energy | 2 | 18.0
| 2 | 13.1 | 0 |
0.0 | 1 | 7.9 |
5 | 44.0 |
RWE Npower | 0 | 0.0
| 3 | 39.6 | 1 |
-3.0 | 1 | 12.7 |
5 | 52.6 |
Scottish and Southern | 1 |
6.7 | 2 | 19.1 |
1 | -5.0 | 1 | 14.2
| 5 | 37.9 |
Scottish Power | 1 | 12.0
| 2 | 18.8 | 1 |
-5.5 | 1 | 14.0 |
5 | 43.3 |
Average | 1 |
9.7 | 2 | 5.7
| 1 | - 5.8 |
1 | 12.3 | 5 | 45.7
|
Source: Company statements, calculations by Energywatch
Table 2.4
HOUSEHOLD GAS PRICE CHANGES LEVIED BY BIG SIX (ANNUALISED)
Company | 2005
| 2006 | 2007
| 2008 | Period
|
Changes | Effect
(%)
| Changes | Effect
(%)
| Changes | Effect
(%)
| Changes | Effect
(%)
| Changes | Effect
(%)
| |
British Gas | 1 | 12.4
| 2 | 37.1 | 2 |
-19.5 | 1 | 15.0 |
6 | 42.7 |
E.ON UK | 1 | 7.2
| 2 | 47.3 | 1 |
-16.0 | 1 | 15.0 |
5 | 52.5 |
EDF Energy | 2 | 19.7
| 2 | 36.5 | 1 |
-10.6 | 1 | 12.9 |
6 | 64.9 |
RWE Npower | 0 | 0.0
| 3 | 53.2 | 1 |
-16.0 | 1 | 17.2 |
5 | 50.9 |
Scottish and Southern | 1 |
9.1 | 2 | 32.3 |
1 | -12.0 | 1 |
15.8 | 5 | 47.1 |
Scottish Power | 2 | 7.7
| 2 | 34.6 | 1 |
-16.5 | 1 | 15.2 |
6 | 39.4 |
Average | 1 |
9.3 | 2 | 40.2
| 1 | -15.1 | 1
| 15.2 | 6 | 49.9
|
Source: Company statements, calculations by Energywatch
As a result of these price changes, the advantages liberalisation
has brought to UK[149]
household consumers have been eroded over the last three years:
between 2004 and 2007, for example, average UK
gas prices to household consumers (excluding taxes measured by
Eurostat) increased by nearly three quarters (72%)[150],
nearly double the increase of 41% seen across peer EU nations[151];
and
household electricity prices have risen 50% in
the UK compared to 15% in the same nations over an equivalent
period. The extent of the disparity in increases is such that
2007 UK prices were within 2% of the average for this peer group
of nations: in 2004 they were a quarter below.
More up to date comparative data from January 2008 is shown
at Figure 2:2 for electricity and at Figure 2:3 for gas. It shows
the same key finding of UK electricity prices now being above
the average of key EU nations once artificial distortions from
taxes are excluded.
Figure 2.2
AVERAGE DOMESTIC ELECTRICITY PRICES ACROSS KEY EU NATIONS
(EXCLUDING TAXES)

Source: Energy Advice, January 2008
Figure 2.3
AVERAGE DOMESTIC GAS PRICES ACROSS KEY EU NATIONS (EXCLUDING
TAXES)

Source: Energy Advice, January 2008
2.3 Impact on business consumers
Business consumers have been hit by even more significant
price increases as contract rates offered by suppliers are more
closely related to the forward curve, which is a key reference
point for the fixed annual contract price and for shorter-term
"floating" indices used by suppliers. Over the past
four years they have seen their international competitiveness
deteriorate markedly.
Eurostat figures for 2007[152]
show that UK electricity prices to business were 3% above the
EU-15 level having been 30% lower just three years previously.
For gas the change is such that UK prices for 2007 were 12% above
the EU-15 level in 2007 having been 15% below in 2004.
The consequences of high energy prices for them have been:
reduced production, which in turn has been a significant
contributor to over 100,000 manufacturing job losses[153];
during 2005-06 this reduction occurred at a time of global expansion
elsewhere;
switching to more environmentally harmful fuels;
some high profile facilities have shut down like
Britannia Zinc's smelter and Imerys china clay; and
a sharp reduction in UK manufacturing investment
even before the current slow-down.
3. BARRIERS TO
EFFECTIVE WHOLESALE
COMPETITION
This chapter addresses the issue of whether and, if so, what
are barriers to effective wholesale competition. It critiques
features of current market operation against criteria and characteristics
established by the European Commission in a recent influential
report on the energy sector. In particular we identify particular
problems in the British electricity sector that seem to be having
a particularly detrimental effect on the operation of downstream
markets.
3.1 The European Commission's five barriers
In February 2006 the European Commission highlighted in its
interim sectoral report[154]
five barriers it believed were inhibiting effective energy market
competition across Europe, especially at the wholesale level.
Attention in Britain triggered by the report tended to focus on
the way the development of competition is being constrained in
Europe and the possible consequences for consumers here through
limitations and distortions on our own markets, especially via
access to the gas interconnector, which links Bacton in Norfolk
to Zeebrugge in Belgium.
The barriers and their primary characteristics they identifiedwhich
they considered widespread on mainland Europeare summarised
in Table 3.1.
Table 3.1
THE EUROPEAN COMMISSION'S FIVE BARRIERS TO COMPETITION
Barrier to | Summary of view from interim sector report
|
competition | Electricity
| Gas |
Market concentration | Most wholesale markets remain national in scope with high levels of concentration in generation, which gives scope for exercising market power.
| At the wholesale level, markets generally maintain the high level of concentration of the pre-liberalisation period.
|
Vertical foreclosure | Vertical integration of generation, supply and network activities has remained a dominant feature in many electricity markets.
| Lack of liquidity and limited access to infrastructure prevent new entrant suppliers from offering their services to the consumer.
|
Market integration | The low level of cross-border trade is insufficient to exert pressure on (dominant) generators in national markets.
| Cross-border sales do not presently exert any significant competitive pressure.
|
Transparency | There is a serious lack of transparency in the electricity wholesale markets that is widely recognised by the sector.
| There is a lack of reliable and timely information on the marketsnormally the lifeblood of healthy competition.
|
Price formation | Price formation is complex, and many users have limited trust in the price formation mechanisms.
| More effective and transparent price formation is needed to deliver the full advantages of market opening to consumers.
|
| |
|
But energywatch believes that each of these five barriers
is an important factor in the current failure of the competitive
wholesale energy markets here in Britain to meet the needs of
all consumers.
The commission's five barriers are relevant for the reasons
set out below:
market concentrationthe increasing search
for scale by a diminishing number of players has become the single
most defining characteristic in the British energy supply markets.
As a consequence wholesale markets are thin or "illiquid",
with modest volumes being traded;
vertical foreclosuresmaller players and
recent entrants are leaving the market because of an inability
to source wholesale product from major established players. As
the charges levied for uncontracted trades (or "cash-out"
prices) are penal,[155]
choosing to forego contracts for injections and offtakes does
not represent a viable option for competing in the market place.
The illiquidity of the electricity wholesale market combined with
these penal cash-out prices has created a position of "double-jeopardy"
for downstream players, who are exposed to systematic and disproportionate
risk compared to the Big Six who are heavily integrated;
market integrationall of the Big Six have
integrated production and supply businesses that primarily focus
on dual fuel propositions to direct debit consumers in the retail
markets. Since 2001, they have become not only larger but also
more integrated, with commercial relationships between energy
production and supply being particularly opaque;
transparencyenergywatch-originated unified
network code modification 006, whose implementation has brought
much greater visibility of offshore gas flows and terminal deliveries
onto the mainland. But there is not publication of information
in other areas, such as supply business profitability and the
terms of trade with upstream affiliates and, it would seem there
is no regulatory interest in this key information; and
price formationwholesale prices are formed
in markets much less liquid than envisaged when the current market
designs for centralised trading were implemented, especially in
the electricity sector and especially beyond the front seasons
that are traded. The use of the forward curve by all the large
suppliers in setting transfer prices and offers to consumers means
down-stream prices reflect the implied costs of marginal trades
on the open markets. These pricing practices have enabled the
full pass through of carbon costs and helped maintain oil-gas
and gas-electricity price linkages, even though the acquisition
costs of the suppliers are very different.
In all cases these factors work against non-integrated players
in the British market, and have contributed to both generators
and suppliers exiting the market. Going forward they have also
created significant barriers to entry.
We set out our arguments in each of these areas in more detail
below, with specific reference to the electricity sector.
3.2 Market concentration
The British market has become much more concentrated since
full competition was introduced, fuelled by the economies of scale
of mass domestic retail markets but also by strong incentives
to integrate that arise from the market structures. Vertical integration
through asset acquisition is effectively being used as a trading
strategy by virtually all the major market participants. This
trend has led to three particular outcomes, all of which have
been detrimental to the functioning of the wholesale markets.
The observations we make apply equally to gas as well as electricity,
but the degree of the problem is much more manifest in the electricity
sector:
first ownership of production assets has become
more concentrated, and many independent generators have left the
market or been swallowed up by the incumbents since 2000 resulting
in significant horizontal concentration;
second there have been a number of supplier failures
and acquisitions. At the same time supplier exits have not been
counter-balanced by any significant new entry over the same period;
and
as a consequence of the first two factors generation
has reintegrated with supply causing significant vertical concentration,
which has led to a failure to create the hoped for levels of market
liquidity, especially in electricity.
3.2.1 Contraction in independent generation
The British generation market saw significant new entry over
the 1990s fuelled by the "dash for gas" and plump pool
prices set by generators. "Asset-light" strategies were
initially preferred whereby suppliers were able to contract with
generators on a long-term basis for firm power. But the collapse
in power prices in 2001-02 in part triggered by surplus generation
led to the exit of many merchant plant operators and the failure
of some over the next two years. Examples are shown in Appendix
2. Several realised huge losses on recent investments through
fire sales, while some went into administration or left their
assets with the banks. At the same time the integrated players
were relatively indifferent to this price collapse as they tended
to have high levels of contract cover in place or had a route
to market through their supply businesses.
Since 2003-04 alone we estimate that the volume of independently-owned
generation, excluding nuclear and long-term arrangements with
the Big Six, has dropped from 70TWh out of annual GB supply of
around 330TWh or so to less than 25TWh on an annualised basis.
These developments made wholesale markets thinner and inherently
more volatile.
3.2.2 Supply consolidation
A parallel development has been the loss of independent supply.
Outside of a small, niche "green" electricity sector,
householders' choices are restricted to the Big Six as they have
absorbed the business activities of smaller competitors that have
left the market or which have been acquired. During 2005-06 in
particular several small players exposed to high and volatile
wholesale prices went out of business. Supplier failures since
2000 are shown at Appendix 3. In all less than 1% of residential
consumers now receive their electricity or gas supply from someone
other than the Big Six.
And in the business markets there has also been a notable
reduction of choice as suppliers have exited the business supply
markets. Statoil and BP, prior to its full withdrawal from the
market, both developed and then disposed of businesses serving
smaller and medium gas users. In electricity the exiting suppliers
have tended to focus on segments of the business markets.
It is to be expected that some enterprises will fail during
periods of high and volatile prices, especially given the increasing
diseconomies of scale in supply. But the combination of wholesale
prices that fell dramatically from early 2007 and inflated consumer
prices presented the biggest potential opportunity for new entrants
seen since competitive markets started. Despite rhetoric from
Ofgem about simplifying market entry and licensing procedures,
entry remains a complex, expensive and time-consuming process.
A range of new licensees have emerged in the gas sector though
as yet few have started actively trading; in electricity there
has been negligible new activity. In turn this has meant that
the incumbent players see no realistic competitive threat from
new entry on any scale.
3.2.3 Vertical reintegration
The adjunct to the exit of players in both generation and
supply is the significant increase in vertical integration. In
the energy markets vertical integration has meant that a market
can now be effectively foreclosed with a few long-term contracts,
and the position is not significantly different in Britain than
it is in continental Europe in this respect. This characteristic
means remaining smaller players and new entrants cannot compete
fairly or effectively. And because most independent generators
have now been acquired by the larger players, the few remaining
independent suppliers must buy from a scale player or from volatile
short-term spot markets if they wish to avoid being "cashed-out".
As a consequence electricity trading activity outside of
the Big Six is largely dependent on them making volumes available
to their competitors, which the market structure disinclines them
from doing. This arises because they wish to hold control of spare
capacity in effect to help themselves self balance or because
they would prefer to do business with other large players, and
their credit policies reflect this preference. Anecdotally they
often cite credit policies for refusing to trade with less substantial
players.
A further effect is that wholesale markets are much less
liquid. This is important to competition as they allow suppliers
and, in some cases, consumers to source bulk energy. After a surge
in the late 1990s, wholesale electricity market activity in Britain
has declined as a result of exit of independent trading and supply
companies and the disappearance of merchant plant.
We consider the issue of poor market liquidity and its implications
further in section 3.3.
3.2.4 Less diversity
Foreclosed markets mean consumers miss out on the benefits
of competition brought by diverse and new players. The advantages
that arise from new entry are not only price related:
smaller suppliers are often new entrants and keep
larger players on their toes through more innovative offerings
and services. They also enable issues about market entry to be
kept under closer focus and barriers to entry to be tackled;
environmentsome smaller players are active
in green and energy service markets. Energy service companies
are emerging that actively pursue low carbon programmes and bespoke
consumer offerings;
security of supplysmall suppliers broaden
the sharing of the funding burden, in particular facilitating
the participation of venture capital providers. On both the generation
and supply sides they have introduced a number of innovative financing
techniques. A further factor is that commodity-based energy markets
introduced in the UK depend on liquid traded markets to enable
reliable price discovery and thus facilitate proper investment
decisions in new capacity, and these smaller players enable more
diverse participation in these markets where they are enabled
to work effectively; and
innovationsmall suppliers introduce innovation,
and a wider diversity of commercial offerings for all types of
consumer.
At a time when the Government is promoting diversity of supply
through its policies, it is perverse that market structure actively
deters diversity of participant.
3.3 Vertical foreclosure
Both electricity and gas markets have created strong incentives
for parties to balance their supply with their production, which
has reinforced drivers to vertical reintegration on a huge scale,
reducing access to markets by smaller players. Above all this
reintegration in industry structure has had a significant impact
on market liquidity.
3.3.1 Market liquidity
The European Commission's interim sector report from 2006
noted: "The UK is the only market in the comparison where
traded volumes [of electricity] have significantly declined during
the last two years. This is often ascribed by respondents to ongoing
vertical reintegration of the industry, ie the trend to bring
independent generation and supply businesses into a single operation
under the same ownership".[156]
The point is illustrated by Figure 3.1, which is extracted from
the report.
Figure 3.1
TRENDS IN OTC ELECTRICITY MARKET LIQUIDITY

Source: European Commission, Preliminary report into the
electricity sector
Data from the UK Financial Services Authority (FSA) shows
that this trend increased in the year to July 2006, with liquidity
in UK power falling a further 6%.[157]
Activity in the markets it regulated increased in its latest report:
electricity volumes were up 52% to 985TWh and gas volumes up 109%
to 437bn therms in the year ending July 2007.[158]
Although these increases appear impressive, the volume of electricity
traded is only three times physical consumptionsome way
below the ten times level said to evidence a healthy market and
means liquidity is still significantly less than markets such
as Germany and the Netherlands that have deregulated more recently.
This unhealthy position is reinforced by data reported by
one of the Big Six, and shown in Table 3.2. The data, from annual
Factbooks produced by RWE,[159]
shows that its trading volumes almost halved over a three year
period, during which volumes traded on the wider wholesale power
market also fell to about a third their previous level. Overall
this source shows a similar level of market activity measured
as a ratio of physical demand as the information from the FSA.
Further analysis on behalf of smaller suppliers shows that typically
aggregate volumes of reported seasonal contract trades scarcely
exceeds the physical amount of power consumed during these six
month periods.
Table 3.2
A VIEW OF ACTIVITY IN THE WHOLESALE POWER MARKET
(TWh) |
2003
|
2004 |
2005
|
2006 | Change
(06 on 03) %
|
Total trading volume | 2,500 |
1,900 | 1,469 | 750
| -70.0% |
RWE trading volume | 501 |
356 | 203 | 272 |
-45.7% |
RWE physical output | 38 |
31 | 31 | 31 | -18.4%
|
GB demand | 317 | 316
| 322 | 322 | 1.6%
|
Trading/demand ratio | 7.9 |
6.0 | 4.6 | 2.3 |
* |
| |
| | | |
Poor UK market liquidity in electricity has been accompanied
by a period where wholesale prices have become much more volatile.
Energywatch believes the two are directly related and reinforcing,
as major players respond by further integrating their upstream
and downstream operations and acquire competitors to ensure they
can balance production with supply to limit their exposure to
wholesale prices. In turn this response limits even further the
volumes available for wholesale trading.
These modest levels of liquidity are not helpful to major
consumers or independent suppliers either as the opportunities
to trade reduce and they therefore tend to be more exposed to
short-term price fluctuations. The volume of electricity traded
on a very short-term basis reported by the London Energy Brokers
Association[160] has
fluctuated in the range 2-3TWh on an annualised basis since 2005.
Most recently there has been a reduction in volumes on a monthly
basis of a third for the November-February winter period of 2007-08
compared with just a year earlier. Ofgem also recently found quantities
of day-ahead trading to be particularly thin in GB compared to
other liberalised markets.[161]
Volumes that are being traded are also heavily skewed to
shorter durations, typically much less than a year and particularly
relating to the front quarter or season. Data on this is hard
to distil because trading is fragmented across a number of exchanges
and brokers, but anecdotal evidence suggests that what trading
there is is "lumpy". There is also a mismatch in terms
of the wholesale products on offer both in terms of shape and
volume relative to the annual contracts that suppliers enter into.
It can be almost impossible for non-integrated players to access
the volumes they need and the "shape" (or the load profile)
of their commitments. In the past there were many more independent
counter-parties with whom to trade and contracts for structured
products such as "load shape 44"[162]
were in demand, but often there are no longer volumes of these
products available. Where there are volumes made available, larger
players often insist that monies are posted in advance because
the credit risk is no longer socialised as it was under the pool
and the scale players are concerned about the credit status of
non-scale players in volatile markets.
While there is much more trading in the gas market, there
are still important questions for policy makers and regulators
that need to be addressed. In its Ensuring effective and efficient
forwards gas markets report for DTI in March 2005, the consultancy
Global Insight suggested that 70% of the gas landed in Britain
was subject to long-term contracts. The balance, 30%, was available
for forward trading. Its analysis also suggested that the majority
of this gas (as we have already seen occurs with electricity)
was traded in the immediate run up to its delivery, rather than
months or seasons ahead. As a consequence forward curve prices
were posted based on very limited trading activity to the extent
that, while the consultant characterised the spot gas market as
"functionally liquid", noting it believed the forward
market to "suffer from a lack of liquidity by global standards".[163]
These arguments provide further evidence that the forward
curve is not a robust indicator of future wholesale costs for
gas suppliersand electricity market liquidity is even lower.
3.4 Market integration
As we have seen, consolidation has become a real feature
of British energy markets and this has given rise to six large
vertically-integrated players who effectively monopolise supply
to domestic consumers. In electricity they have as a consequence
effectively opted out of wholesale power trading for a significant
part of their operations, and they increasingly seek to lock in
wholesale volumes of gas by entering into long-term contracts
for gas supplies or in some cases acquiring their own gas production
assets.
Figure 3.2 illustrates this point for electricity, and compares
aggregated settlement data for suppliers for the year ending March
2007 with published data on generation production.
Figure 3.2
A "BALANCED MARKET"

Source: Cornwall Energy, using data from Berr, Ofgem, Elexon
The figure shows total retail sales below the line to both
domestic and business consumers. However it does not distinguish
between sales to domestic and business consumers. Apart from Centrica,
all of the Big Six are "net long" with their generation
volumes exceeding domestic sales, and a strong dynamic in the
market has been to make sure that domestic sales can be sourced
from in-house generation, a phenomenon we call the "balanced
market". Again, apart from Centrica, all have access to coal
generation and, in some cases, other fuel sources. They are not
wholly exposed to the gas and carbon prices that have become the
key driver of forward power prices. In fact the great surge in
coal consumption at power stations over the 2005 and 2006 period
was one direct consequence of their desire to avoid a gas price
exposure.
There are two implications flowing from these observations:
comparing electricity sales volumes of the major
suppliers with output from their power stations shows the major
players are targeting their in-house generation output at their
"sticky" small business and domestic consumers who are
paying the published tariff rates; and
their ability or willingness to compete in the
business markets depends on any surplus volumes they have after
allowing for supply to their domestic consumers, and traded volumes
and their contract price offers at any particular time reflect
market prices irrespective of whether they are exposed to them
in whole or in part.
These implications and their impact on the retail markets
is discussed further in chapter 5.
3.5 Transparency
Despite the relatively good transparency in the British real-time
market compared to Europe, European regulators through Ergeg have
shown[164] there are
areas where transparency in the British market remains poor. There
are important aspects of wholesale market functioning that are
inhibiting visibility of participant actions, which hinders and
distorts understanding of integrated operations.
Energywatch believes that given the level of vertical integration
in the market, disclosure requirements are inadequate. Further
there is no systematic reporting by activity to Ofgem and no meaningful
reporting in turn to the wider market. Given the ability of the
Big Six to set their own terms of trade, especially through transfer
prices they set themselves, there is a need for urgent consideration
of these issues.
3.6 Price formation
Issues of market dominance and transparency reinforce each
other when it comes to wholesale price formation but they impact
on market participants in different ways. Current market structures
mean independent suppliers and purchasers in both gas and electricity
wholesale markets are price takers; they must pay whatever rates
are on offer as the demand they supply is largely inelastic. In
contrast, the companies which provide them with energy do their
best to mitigate their exposure to these markets by purchasing
assets or, in the case of generating fuels, seeking to trade on
different terms. Nevertheless the concept of the "forward
curve" is central to both sets of trading counterparties.
3.6.1 Forward curve
At any point in time both electricity and gas will have a
unique value, reflecting fundamentals such as the underlying costs
they are referenced against, the balance between supply and demand
and also the sentiment of those buying and selling. The price
at any particular point in time will vary also according to the
point of delivery. Thus the price for gas will depend on the point
at which it is to be consumed. Market reporters thus quote prices
for the annual gas contract in 2008 reflecting views on its average
cost over the year, and this is likely to have a different price
from the 2009 contract. Likewise the average price for the contracts
over either of those years will have different underlying seasonal
prices (summer, winter), and the prices of seasonal contracts
in turn will have different values to the component monthly contracts,
and so forth.
Reflecting these different delivery times price reporters
conventionally quote a forward curve, which shows at any particular
point in time the traded price for contracts in that commodity
across the range of delivery times. A key variable for each point
on the forward curve is the volume of trades that occurs for each
quoted contract. This facet of trading is termed "liquidity".
A liquid market is one where there is a meaningful volume of trading,
which in turn usually enables a representative traded price to
be reported. Conversely an illiquid market is one where there
is limited trading taking place, and the price is likely to be
formed on the basis of a few transactions or even a single trade.
In turn illiquid markets are usually considered to be volatile
and the price discovered does not necessarily reflect the market
value.
Limited market liquidity is a key feature of the current
energy landscape, and for electricity the situation is especially
poor and has deteriorated over recent years. But this trend has
occurred at the same time as the prices it produces have become
more important for setting consumer prices. Large user prices
in the business markets in particular are usually based on the
traded year ahead price derived from the forward curve, to which
the supplier adds grid charges, taxes and its profit margin, unless
the consumer opts to link their prices to shorter-term measures
in the expectation the price will fall closer to delivery.
But as we have seen from recent announcements of price rises,
the Big Six reference movements in the forward curve in setting
their retail prices. This is important not because the suppliers
are necessarily exposed to these prices for significant volumes
but because the wholesale forward curve, for electricity in particular,
is essentially used as a reference price for transactions between
different operations of these integrated companies. As a result
prices to consumers are not necessarily related to the company's
costs of production. While the major players conduct limited forward
trading, reflected by declining liquidity, they still use the
forward curve it produces as the indicator of costs when they
want to change prices.
Unfortunately financial reporting by the Big Six is insufficiently
transparent to make definitive judgments on these matters, and
we believe this lack of disclosure of trading between affiliates
and of transfer represents a major failing that needs to be addressed.
Until recently Centrica's accounts showed that the average selling
price for its upstream gas exceeded its average purchase cost
for supply onto domestic consumers.[165]
This position suggests Centrica has decided to price its equity
gas at the forward curve while purchasing from others at lower
non-forward curve related terms. Figure 3.3 illustrates this point,
though unfortunately it stopped reporting this information in
late 2006.
Figure 3.3
CENTRICA'S REPORTED AVERAGE WHOLESALE GAS SELLING PRICE
AND AVERAGE COST OF GAS FOR SUPPLY TO HOUSEHOLD CONSUMERS

Source: Energywatch from Centrica financial reports
3.6.2 Other wholesale pricing matters
There are two further points about current wholesale market
pricing that Energywatch believes are damaging the British market
and further distort the wholesale price setting process. Expressed
as questions they are:
why should wholesale power prices be linked to
gas prices (and in turn gas to oil); and
why should new carbon costs be passed through
at marginal cost in power prices?
Power-gas linkage
The "spark spread" relationship[166]
between wholesale gas and power prices is long-established, with
gas remaining the fuel of choice for new investments in power
generation. A threshold of about £10/MWh of electricity prices
over gas prices is usually seen by developers as the minimum margin
required for commercial pay back in new generation plant using
gas as a fuel. Spark spreads have scarcely attained those levels
over recent years, theoretically making new investment in gas
generation unviable.
Figure 3.4
SPARK SPREADS

Source: Heren data
While poor returns have undoubtedly squeezed some in the
independent generation sector, we think the commercial dynamic
is more complex than this. Many gas-fired stations in (and outside)
Big Six ownership have long-term fuel supply contracts priced
using other price indicators. Centrica's LTI[167]
is the best known variant, and it reported its Industrial and
Wholesale business selling significant volumes at average prices
below 30p/therm during 2005-06. If all of this gas were burnt
in base-load CCGTs at this rate, it would fire approximately 6.5GW
(equivalent to 26% of capacity) at around £15/MWh.
We have no means of knowing if it all is, but on the other
hand we do not believe that all other gas burnt in power stations
is priced at market prices, especially given some of the valuations
put on such contracts in power station acquisition transactions
over recent years. Coal and nuclear generation, which together
account for over 50% of power production in 2005, have different
economics, and at least until recent when coal prices have soared,
these generators have been similarly earning bumper returns from
a market regime driven by high market gas prices.
In short there is significant circumstantial evidence that
power producers have been able to earn extensive windfall profits
as a result of the real relationships between costs and prices
even before the impact of carbon pricing is taken into account.
Carbon windfalls
The EU emissions trading scheme was implemented in January
2005. Free carbon allocations of a half to 70% of their requirements
under it have earned windfall profits for generators. They have
been able to pass through the full marginal cost of carbon into
power prices. The view from the City is that full pass-through
occurs where the wholesale power market is not competitive.
The costs that consumers bear as a result of this were estimated
to be in excess of £1 billion a year in 2005 and 2006, and
Ofgem has recently noted that British generators will be making
a further windfall of 9 billion over the second phase of
the scheme between 2008-12.
We comment further on this issue in chapter 4.
4. LINKAGE BETWEEN
WHOLESALE AND
RETAIL MARKETS
In this chapter we consider the importance of wholesale prices
in setting retail prices. It also examines new environmental costs
that are impacting on suppliers and their consumers. The relationship
described by suppliers between wholesale costs and retail prices
is now a major concern to Energywatch, and the convergence between
suppliers' prices, pricing structures and product offerings is
also an issue we are worried about.
4.1 Construction of the retail price
Irrespective of how a tariff to supply electricity or gas
to a householder is presented, in preparing it suppliers will
assess separately the different costs in the supply chain, namely:
fuel, including what the supplier pays for the
wholesale energy, which in turn includes producer profits, any
costs of carbon permits for power generators and gas storage;
the suppliers' own costs of servicing the consumer,
including metering and its profit margin;
charges for using the delivery networks of transmission
and distribution, from production facility to the consumer's meter;
the costs of complying with regulated obligations
to stimulate renewables and energy efficiency activity; and
Below we comment briefly on these elements.
4.1.1 Fuel costs
Suppliers secure bulk volumes of fuel for their consumers'
requirements. The wholesale cost they pay will be determined by
the commercial arrangements they have in place to secure that
energy. These arrangements may involve:
production from assets owned by upstream affiliates.
This option is a particularly important one in electricity where
the Big Six own more than half of British generating capacity
as well supplying the vast majority of household consumers;
long-term contracts with producers. Many gas fields
have been developed as a result of "life-of-field" contracts
with suppliers. These arrangements typically pre-date the liberalised
era when it was customary for bulk gas prices to be indexed to
changes in other indicators such as oil prices. Other contracts
for gas and electricityespecially the most recent and those
for imported gasmay include rates linked to published wholesale
market indicators. In electricity some long-term "tolling"
arrangements are in place where the supplier pays the generator
an operating fee plus separately itemised fuel and, as necessary,
carbon costs; and
shorter-term purchasesfor periods running
from days to low numbers of yearsof energy at rates linked
to published wholesale market or trading exchange indicators or
"over-the-counter" transactions facilitated by brokers.
4.1.2 Suppliers' own costs
Suppliers' own costs of serving their consumers include their
administrative and service functions, as well as managing the
cashflows in their businesses. Suppliers also incur external costs
for metering equipment and meter reading, though some suppliers
carry out these activities themselves.
4.1.3 Network use of system costs
The delivery of energy through the gas and electricity networks
to consumer meters is not competitive, and a number of companies
operate monopoly services transmitting and distributing energy
around the country. Network use by producers and suppliers is
provided on a regulated non-discriminatory, open access basis.
This framework means that network operators cannot deny a reasonable
request from a licensed supplier for access and must offer fair
and transparent terms. Transmission and distribution network use
of system charges are published and based on principles approved
by Ofgem, with the regulator also periodically setting the total
allowed revenues that the network operator can earn.
4.1.4 Regulated obligations
Suppliers also face two specific additional on-costs from
regulated obligations when they choose to service the domestic
market:
the Renewables Obligation (RO) for electricity;
and
the Carbon Emissions Reduction Target (Cert),
which from 1 April 2008 will replace the Energy Efficiency Commitment
(Eec), for both electricity and gas.
The RO obliges suppliers to buy a certain amount of the electricity
they supply to consumers from qualifying renewable power sources
or pay a "buy-out" charge. A similar obligation exists
for energy efficiency but on both gas and electricity sales, with
suppliers having to demonstrate they have implemented measures
that have enabled consumers to reduce consumption. The shift from
the Eec to the Cert will see the basis of this obligation change
to carbon reduction from energy savings.
Suppliers endeavour to pass on to consumers their costs in
complying with the RO and Cert/Eec, although there is no legal
obligation on them to do so.
4.1.5 Value Added Tax
Electricity and gas consumption by household consumers attracts
Value Added Tax (VAT) at the rate of 5%.
Figure 4.1 shows a breakdown of the average household electricity
bill in Great Britain for a medium user supplied on standard credit
terms. Fuel and the suppliers' own costs account for 70% of the
bill, with the next highest component being network costs at 19%.
Figure 4.1
BREAKDOWN OF AVERAGE HOUSEHOLD ELECTRICITY BILL MARCH
2008

Source: Analysis of Energywatch pricing data for a 3,300kWh
standard supply on standard credit terms
Figure 4.2 repeats this calculation for gas.
Figure 4.2
BREAKDOWN OF AVERAGE HOUSEHOLD GAS BILL MARCH 2008

Source: Analysis of Energywatch pricing data for a 20,500kWh
standard supply on standard credit terms
4.2 Representing fuel price movements
As we have seen a feature of Britain's traded wholesale markets
for electricity and gas is their volatility and their sensitivity
to international commodity prices for oil, gas, carbon and coal.
Comparing household price increases with movements in the year-ahead
forward price for the appropriate fuels shows that movements in
the former can and have lagged the latter, as shown at Figures
4.3 and 4.4. These charts also show that wholesale prices reached
their previous peak in the early summer of 2006, while household
prices appear to have peaked in the late winter of 2006-07. This
cycling suggests a six- to nine-month lag, and this is sometimes
explained by the companies as representing suppliers committing
to forward purchases to secure winter supplies.
But:
in electricity five of the Big Six (Centrica is
the exception) are "long in generation" compared to
expected domestic demand, and the gas and coal for their power
stations will not necessarily be secured at prices directly related
to forward curves; and
in gas many of the major players have to some
extent access to long-term contracts, which are again priced at
historic rates that have risen perhaps by inflation but which
have not risen in real terms.
Many of these arrangements for fuel supply are long-term
and were put in place in the 1990s. As they lapse, their volumes
are much more likely to be replaced by arrangements where there
is a closer correlation of prices to forward curves. This shift
may explain why over recent months there appears to have been
a quicker pass-through of forward curve price changes into household
rates. But even so, Energywatch is very concerned that internal
transfer pricing arrangements mean the supply operations of the
Big Six must pay forward curve-related prices for their energy,
while their upstream production counterparts profit by any difference
between these levels and what is actually paid for fuel in bulk.
Figure 4.3
TRENDS IN BASELOAD (YEAR AHEAD) WHOLESALE GAS PRICES AND
HOUSEHOLD PRICE INCREASES SINCE SEPTEMBER 2004

Figure 4.4
TRENDS IN BASELOAD (YEAR AHEAD) WHOLESALE ELECTRICITY
PRICES AND HOUSEHOLD PRICE INCREASES SINCE SEPTEMBER 2004

4.3 Importance of fuel costs
The assessment shown at Table 4.1 suggests that average householder
bills increased by 2.7p/kWh between 2004 and 2007. Generators
fossil fuel costs increased by 0.69p/kWh over the same period,
about one quarter of this level. While we do not know the commercial
positions of individual companies, the shift away from gas to
coal in the generation mix during 2005-06 and a subsequent reversal
is a matter of record. It suggests that generators have managed
their fuel requirements to minimise the impact on their costs,
while at the same time prices paid by consumers have increased
by an altogether different factor. This disparity between costs,
prices and profits is illustrated at Table 4.1, and this issue
needs to be investigated.
Table 4.1
AVERAGE HOUSEHOLD PRICES AND GENERATOR FUEL COSTS 2000-07
(p/kWh) |
Average domestic
bill (£)
|
Average domestic
bill (p/kWh)
| Calculated average
fossil fuel cost for
generation
|
Difference |
2000 | 257 | 7.79
| 1.23 | 6.56 |
2001 | 245 | 7.41
| 1.36 | 6.05 |
2002 | 236 | 7.17
| 1.27 | 5.90 |
2003 | 230 | 6.98
| 1.30 | 5.68 |
2004 | 230 | 6.98
| 1.46 | 5.52 |
2005 | 251 | 7.59
| 1.84 | 5.75 |
2006 | 290 | 8.78
| 2.16 | 6.62 |
2007 | 320 | 9.68
| 2.15 | 7.54 |
Change 2007 on 2004 | 89 |
2.70 | 0.69 | 2.01
|
Base data from DTI with further calculations by Energywatch. Figures
on costs of fossil fuel generation for 2007 are for the first
nine months of the year only. Average domestic bill is UK-wide
and for a standard supply of 33MWh on standard credit terms.
4.4 Carbon windfalls
The first phase of the EU Emissions Trading Scheme (ETS)
commenced on 1 January 2005 for three years, and 1 January 2008
saw it move into its second phase. The ETS is a "cap and
trade" scheme designed to reduce emissions of carbon dioxide
emissions from major producers, including power generators. Producers
must present enough allowances or permits every year issued under
the scheme to match their emissions of carbon dioxide. Scheme
participants received an allocation of these allowances based
on their historic production at no cost while the basic principles
of the new arrangement were tested. Allocations to generators
have been cut back under phase 2 but still cover the majority
of expected emissions. Individual generators have had to purchase
extra permits at market rates to ensure their overall holdings
which they surrender match their emissions.
But independent research[168]
has highlighted the pass-through by generators into their wholesale
selling prices of their full marginal costs of carbon, despite
the significant free allocations. The authors suggested that this
pass through was at levels "around the marginal intensity
of coal plant, implying possible over-recovery of true marginal
costs by the industry". Further they suggested the combination
of free allocations with full pass-through of marginal costs transferred
approximately £800mn/year from UK consumers to power generators
over the period 2005-07.
Historically, there has been minimal regulatory scrutiny
of forward energy markets, even though Ofgem has recently acknowledged
the windfalls being accrued through the full pass-through of carbon
costs by generators. It went as far as suggesting that generators
would make a further 9 billion windfall gain as a result
of phase 2 of the EU ETS.[169]
Energywatch thinks this pass-through underlines the ability
of large, integrated players to disengage from the traded wholesale
markets but to signal prices to retail consumers from a forward
curve that reflects marginal costs to which they largely are not
exposed. We are also perplexed as to how Ofgem can assert that
markets are functioning properly when the marginal carbon cost
is being charged in full despite extensive free allocations. It
is also acquiescent to the full costs being passed through in
transfer prices and be charged in full to retail consumers.
4.5 New environmental costs
On announcing their recent price increases a number of suppliers
have drawn attention to the increasing costs they face of complying
with the RO and the Cert (see Section 4.1.4):
EDF Energy said "The doubling of the energy
efficiency programme, now called the Cert will, cost our consumers
up to £100 million per annum over the next three years";
British Gas said that the typical household consumer
would be paying £31 each year of compliance costs for the
Cert and £12 each year for the RO; and
RWE Npower said: "The spend to meet the government's
energy efficiency targets (now called Cert) has doubled and Npower
will be spending around £300 million on energy efficiency
measures for consumers over the next three years".
There is an increased commitment by suppliers for spending
on energy savings with the Cert. But, the new scheme is not introduced
until 1 April 2008, meaning that as the price changes announced
by all three companies predate this point. So Energywatch is concerned
that, by moving early, most of the Big Six suppliers will effectively
have been charging their consumers the costs of a scheme that
is not yet in force.[170]
Likewise there is an increase of 9% in the cost to consumers of
the RO that takes effect from 1 April, as a result of a higher
target from that date although its impact on bills was at the
time of raising prices for five of the companies much less marked.
5. BARRIERS TO
EFFECTIVE RETAIL
COMPETITION
Energywatch believes that levels of true competition in retail
markets for gas and electricity is greatly exaggerated by British
policy makers and regulators, and real distortions in the market
are being ignored. This chapter addresses:
our contention that there remains considerable
regional market power;
the dominating characteristic for suppliers to
target certain types of consumer but not others;
the limited usefulness of switching data as a
measure of effective retail competition;
arguments that factors other than costs are relevant
in setting consumer prices; and
barriers to competition in retail markets.
5.1 Domestic competition
A decade after the first household gas consumers gained the
right to choose their supplier competition for domestic consumers
remains strongly focused between the local electricity supplieror
rather in many cases the company that acquired that organisationand
the privatised successor of the British Gas Board. In the gas
sector the same players monopolise the domestic market, and five
of the same six companies have shares between 7-13%, with the
largest supplier still retaining almost a 50% share.
With over eight years of competition in the domestic electricity
markets, a similar picture applies. The latest published Ofgem
figures at March 2007 show the Big Six have market shares between
12-22%, with relatively stable market shares.
The Ofgem figures are shown at Tables 5.1 (electricity) and
5.2 (gas) respectively. This snapshot of progress, most recently
taken in June 2007 to reflect the position at end March 2007 and
which we think is taken too infrequently in a volatile marketplace,
suggests a picture of continuing retail market concentration.
Energywatch also believes this national overview conceals
the unevenness of competition among different regions and consumer
categories. Competition is sometimes not as vigorous and widespread
as is claimed by Ofgem, and competition has not benefitted some
consumer classes at all.
5.1.1 Regional markets
The domestic retail markets have strong regional characteristics,
and the dominant players are the successor companies to the pre-liberalisation
electricity and gas incumbents. Five of the six whose core business
originated in electricity retain high levels of market share in
their original licensed areas ("in-area"), with much
lower levels of consumer success outside of these historic supply
areas ("out-of-area"). And as we will see it is in these
historic areas that they seek most aggressively to acquire new
gas consumers.
The latest figures from Ofgem[171]
showed that in March 2007 in six of the 14 electricity supply
regions in Britain the home supplier still holds more than half
the market, and in some cases considerably more. Berr data also
shows that in four of the 12 gas regions British Gas retained
more than half of the consumers at the same date. Data comparing
regional switching levels for both fuels is summarised[172]
in Figure 5.1.
Table 5.1
SHARES OF THE HOUSEHOLD ELECTRICITY MARKET
Electricity | June 2005
| September 2005 | March 2006
| March 2007 |
British Gas | 22% | 22%
| 22% | 22% |
E.ON UK | 21% | 20%
| 20% | 19% |
EDF Energy | 13% | 13%
| 13% | 14% |
RWE npower | 15% | 15%
| 15% | 16% |
Scottish and Southern Energy | 16%
| 16% | 16% | 18%
|
Scottish Power | 13% | 13%
| 13% | 12% |
Others | 1% | 1%
| 0% | 0% |
Source: Ofgem
Table 5.2
SHARES OF THE HOUSEHOLD GAS MARKET
Electricity | June 2005
| September 2005 | March 2006
| March 2007 |
British Gas | 53% | 53%
| 52% | 47% |
E.ON UK | 14% | 14%
| 13% | 13% |
EDF Energy | 5% | 5%
| 6% | 7% |
RWE npower | 9% | 9%
| 10% | 12% |
Scottish and Southern Energy | 9%
| 10% | 10% | 13%
|
Scottish Power | 9% | 9%
| 9% | 9% |
Others | 0% | 0%
| 0% | 0% |
Source: Ofgem
Figure 5.1
PROPORTION OF CONSUMERS WHO HAVE NOT SWITCHED BY REGIONMARCH
2007

Source: ElectricityOfgem March 2007. GasBerr
figures with further calculations by Energywatch.[173]
The information at Figure 5.1 highlights two further points:
some areas of relatively low switching by electricity
consumers are characterised by high switching of gas consumers.
Examples include South Wales, Southern England and the North of
Scotland. The owner of the three respective incumbent electricity
suppliers is Scottish and Southern Energy; and conversely,
some areas of relatively high switching by electricity
consumers are characterised by low switching of gas consumers.
Examples here are the West Midlands, North West and North East.
These two points would seem to underline the point that the
main competitive dynamic is based around dual fuel (combined electricity
and gas offerings) between the successors to the previous local
state gas and electricity boards.
In Energywatch's opinion this situation does not indicate
vigorous and healthy competition in a national market with multiple
national suppliers. Rather it underlines the regional nature of
household energy supply competition and the prevalence of strong
legacy relationships.
If the electricity market was looked at on a regional basis,
it remains highly concentrated. The published information at the
regional level is current at April 2005, but it shows regional
measures of market concentration are in the range 3,000-5,000
in all but one instance which is significantly higher, as illustrated
at Figure 5.2. Analysis suggests the regional position has not
changed significantly since.
Figure 5.2
REGIONAL DOMESTIC ELECTRICITY HHIsAPRIL 2005

HHI refers to the Herfindahl-Hirschman Index, a commonly
accepted measure of market concentration used by economists. It
is calculated by squaring the market share of each firm competing
in the market and then summing the resulting numbers. It therefore
takes into account the relative size and distribution of the firms
in a market and approaches zero when a market consists of a large
number of firms of relatively equal size. The HHI increases both
as the number of firms in the market decreases and as the disparity
in size between those firms increases.
Markets in which the HHI is between 1,000 and 1,800 points
are considered by the US Department of Justice to be moderately
concentrated, and those in which the HHI is in excess of 1800
points are considered to be highly concentrated. Transactions
that increase the HHI by more than 100 points in concentrated
markets presumptively raise antitrust concerns under the Horizontal
Merger Guidelines issued by the U.S. Department of Justice and
the Federal Trade Commission.
http://www.usdoj.gov/atr/public/testimony/hhi.htm
The national values for the domestic electricity market has
fluctuated between 1,700 and 1,800 since December 2002, and based
on the latest Ofgem data was at just over 1,760 at March 2007.
The gas market does exhibit less of a regional definition
of markets than electricity, but because of the focus on dual
fuel propositions some of the regional marketing typical of electricity
is shared with gas.
5.1.2 Consumer differentiation
Looking at pricing data routinely published on the energywatch
website, there are a number of other noticeable factors as well
as the prevalence of regional markets that suggest significant
distortions have existed in the retail sector:
competition remains most vigorous for direct debit
consumers;
in many cases some competing suppliers do not
try to beat the incumbent price, with typically only one out-of-area
supplier competing aggressively at any one time;
prepayment consumers generally see the least good
offers with wide differentials over direct debit and standard
credit consumers, especially in gas;
as we have noted incumbent prices for the non-traditional
fuel are usually much more aggressively priced than for the traditional
fuel, implying the incumbent can rely on retention despite not
being the cheapest provider for its traditional fuel;
two-tier pricing whereby a supplier will offer
different levels of prices between in-area and out-of-area still
seems to be prevalent despite the removal of the supply price
controls, with some suppliers offering cheaper tariffs out-of-area
than in-area; and
some suppliers adopt specific regional strategies
and sectoral strategies depending on their overall supply positions
at any particular point in time.
For dual fuel accounts there have been relatively attractive
deals for direct debit monthly payment consumers, though there
are growing similarities in how suppliers price such deals as
we see below. Consumers of both services have been able to shop
around at the end of their deal, and it is estimated that multiple
switchers of this consumer type account for over a quarter of
the total switching in the market.
Even here in this relatively healthy segment of the market
academic research suggests there are issues that require regulatory
examination. Analysis by Richard Green noted in 2005 that 80%
of those who switched move to a dual fuel deal, which tended to
be at a lower price than buying the two fuels separately (as they
should owing to saved account management and billing costs). However
Green notes that "Typically a company will stress the low
price it can offer for its non-traditional fuel, while avoiding
the subject of the high price it is still charging as an incumbent.
The low price in the non-traditional market may not leave much
of a profit margin (which is not to say that it is actually predatory),
but has the great advantage of helping to retain consumers in
the traditional market, where margins remain much higher".[174]
But for otherseffectively the rest but especially
the fuel poor, other vulnerable consumers and those with prepayment
metersthere is little real competition as emphasised by
Ofgem's call in 2006 for the Big Six to be lenient on post recalibration
price changes. More recently, in late January 2008, the regulator
used its review of debt and disconnection[175]
to report that RWE Npower was a supplier whose "procedures
for dealing with consumers in debt needed to be improved to bring
them into line with best practice".
5.1.3 Exaggerated switching levels
The health of the market is usually assessed by Ofgem by
reference to switching data. Energywatch believes that disproportionate
emphasis is placed on this measure, and the conclusions drawn
from it can be misleading, not least because multiple switchers
and mis-selling transfers are routinely included in the figures
quoted.
In April 2007 when Centrica announced its second price cut
Ofgem chief executive said "Consumers are firmly in the driving
seat and over 600,000 switched in the first two months of [2007]
alone". But Ofgem's own statistics can be read differently,
and say:
85% of consumers did not use their right to switch
energy supplier in 2006, a year during which the major suppliers
levied multiple increases between them;
switching only increased year-on-year marginally
in the first seven months of 2007the latest period for
which figures are availableto 2.8 million households for
electricity (compared with 2.6 million in the same period a year
earlier) and 2.3 million for gas (compared with 2.2 million).
This change occurred against a background of the first price reductions
for many years by suppliers;
research commissioned by the National Consumer
Council found that 55% of consumers were unlikely to consider
switching or re-switching in both March 2006 and March 2007; and
nearly half of domestic consumers are still supplied
by their incumbent electricity or gas supplier after over a decade
of open markets.
Instead of taking account of this market fundamental and
the evolution of an homogenous dual fuel market, the current regulatory
focus centres on the number of switches by fuel (not switchers),
despite the fact that significant numbers of consumers have still
never changed supplier. Further academic research suggests that
a large number of people who have not switched wrongly believe
that the incumbent will reduce price to match competitive prices,
which is erroneous.
And despite much publicity from the regulator, net switching
levels have only increased slightly over the last three years
of higher prices. BERR figures show 36% of direct debit consumers
served by British Gas at September 2007, a reduction of seven
percentage points in a year from 43%. Equivalent figures for electricity
are 39% and 43%, a four percentage point reduction. These figures
show much the rosiest view of switching as a measure of competition.
In contrast six in ten gas consumers on prepayment terms are served
by British Gas, and for electricity incumbents retain a half of
all these users. More than a half of those on credit terms for
gas or electricity remain with their incumbents. We have argued
for some time that these differences between types of consumer
are significant and require much more focus by Ofgem.
5.1.4 Relative pricing
There is also plenty of comment from the City on retail markets
and price movements, which tend to reinforce Energywatch's interpretation
of competitive activity in gas and electricity retail markets.
In general its tone is markedly less bullish than the regulator's
about the vigour of competition. Recent comment has tended to
highlight the limitations of price reductions last year and the
controlled nature of opportunistic price increases this year,
as well as the ability the suppliers will have to pass on to their
other consumers the increased contribution to their social tariffs
the Chancellor of the Exchequer asked them to make in the 2008
budget.
Back in February 2007 when limited price reductions were
levied Merrill Lynch commented, "In our view, the recent
price cuts do not constitute a price war. The magnitude of competitor
reductions across all tariffs will depend largely upon each company's
forward hedge position in wholesale gas and power, and the assumed
desire to repair retail margins, particularly in gas".
Citigroup greeted EDF Energy's cut in gas prices (levied
on 15 June but announced six weeks earlier on 30 April) with the
comment: "The UK supply companies are acting as we expected,
with price reductions such as EDF Energy's merely bringing them
in line with the rest of the sector. We argued that the likelihood
of a price war as wholesale energy prices fell was remote. This
is because the vertically-integrated generator/suppliers need
to rebalance their profits so that they earn sufficient returns
from supply to make up for sharply falling generation profits
this year compared to 2005 and 2006".
And UBS's opinion on the last company to reduce prices in
2007 was that "While price cuts will reduce the profitability
of Scottish Power's supply business, at this point in time, we
don't see evidences of a `price war' between suppliers, but rather
evidence of an ordered and disciplined market".
More recent pricing developments have also attracted comment
that highlights limits on competition in the market-place:
"the generator/suppliers such as RWE no longer
have the luxury of bumper generation profits to cushion retail
price increases . . . the industry as a whole will be seeking
to ensure reasonable levels of profitability from supply";
Citigroup 4 January 2008;
moreover, the media attention has for once focused
elsewhere "this time round Centrica was actually the third
company to increase prices, and only Scottish and Southern Energy
has [to that point] resisted raising its prices. Therefore there
is currently no material price difference between Centrica and
four its competitors"; Citigroup 19 February 2008; and
"the government has asked the companies to
work with Ofgem to ensure that prepayment consumers, who pay higher
bills, get a fair deal [in the 2008 budget]. This will inevitably
be a negotiated compromise. But even in the worst case, if the
supply industry equalized tariffs, this cost could be recouped
with a 1-3% tariff increase"; Morgan Stanley 12 March 2008.
These observations are from a class of stakeholder that tend
to be better informed than most.
They are further backed up by the recent prices set by retailers
in their core focus market, dual fuel consumers on direct debit
terms, as shown at Table 5.3. The difference between the highest
and lowest dual offers of the Big Six is just £48 on a typical
spend of £1,000 or so, with five of the Big Six being bunched
within a £13 band.
Table 5.3
COSTS OF DUAL FUEL OFFERS AT 1 APRIL 2008GB AVERAGE,
DIRECT DEBIT TERMS FOR A MEDIUM USER
Dual FuelMedium User
| Scottish
Power | EDF
Energy
| British
Gas |
E.ON UK
| RWE
Npower |
SSE
|
Average direct debit | £971
| £1,010 | £982 |
£999 | £1,014 | £966
|
Average standard credit | £1,111
| £1,035 | £1,070 |
£1,063 | £1,056 | £1,024
|
Average PPM | £1,062 |
£1,045 | £1,144 | £1,097
| £1,126 | £1,068 |
Source: Energywatch
It is no surprise then that some stakeholders believe there
is a strong case to be answered by the Big Six with regard to
tacit collusion.
5.2 Business consumers
There are similar trends in concentration and discretionary
competition in the business sector as in the domestic sector.
Five of the Big Six plus British Energy emerge as the most important
suppliers. According to Elexon data, Gaz de France Energy Supply
Services is the only supplier with a non-privatised industry heritage
to hold a volume share of the electricity market in excess of
2%, although there are a few niche providers with shares below
that level. There has been broad stability in shares amongst the
major players in the business sector since the failure and withdrawal
from the market by Maverick Energy and Atlantic Gas and Electricity
in 2004.
In fact in the business markets scarcely 2% of power volume
is supplied by operators who do not own at least one major power
station. Consumers in the business sector are also suffering because
the regional nature of competitive energy markets often limits
their choice of supplier, and it is commonplace for many smaller
business consumers to receive few offers at renewal. Despite this
business users have traditionally been deemed commercially aware
enough not to require the specific protections in place for household
consumers.
But many small businesses in particular have a low level
of knowledge of the opportunities open to them from energy supply
competition, especially when the use of different brands by some
of the major suppliers can confuse, leaving them with the perception
that there is more competition in the market than is actually
the case. They also have difficulties obtaining and evaluating
offers from competing suppliers, given a perceived non-comparability
of terms and a general lack of transparency. Energywatch pushed
hard forand therefore welcomesthe provision for
redress schemes to cover micro-business as well as household users.
In November 2004, because we were concerned that the state
of business markets was being neglected by the regulator, Energywatch
published a major report on business energy supply markets in
Britain.[176] This
report noted that supplier activity varied by sector and by negotiating
round, and there will strong regional characteristics in these
markets. It also highlighted the need for much more structured
and routine information gathering on the health of these markets,
which we concluded was worse than regulatory statements suggested.
Many of the comments we made then still apply today. At various
times since some of the major suppliers have made plain the terms
on which they wish to compete, if at all, in competitive business
supply markets. Two examples underline this point. E.ON UK posted
a 20% year-on-year reduction in gas sales to industry to 30 September
2006 reflecting "a focus on margin rather than volume".
Separately, Scottish Power's chief executive Philip Bowman talked
of "deliberately constraining" the growth of his company's
supply business in December 2006 because of its being "loss-making
when measured against current wholesale prices".
We believe these examples reflect the market power held by
suppliers in the current trading environment. They can choose
the extent to which they wish to engage with consumers, which
cannot be conducive to the health of the sector.
5.3 Lack of innovation
Despite some signs of development around micro-generation,
there is also a lack of innovation from six large, slow-moving
corporations more intent on retaining their powerful regional
franchises rather than seeking to develop new opportunities. Such
innovation as there has been to date from the Big Six, like wholesale
price tracker offerings and online tariffs, is tinkering around
the edges and are unexceptional changes in rapidly changing markets.
Major opportunities to deliver consumer benefits are being
over-looked or ignored. Areas where much greater activity should
be expected include:
energy savings through more efficient use facilitated
by a large-scale roll out of smart metering. Most consumers will
still have to wait several years for real activity even if the
regional franchise proposal sponsored by the Energy Retail Association[177]
is implemented;
the offer of time-of-use tariffs; and
the development of energy savings services and
stimulation of micro-generation to improve supply security and
reduce emissions by cutting demand on the public network.
Whilst Energywatch notes with interest the recent launch
of British Gas New Energy and other recent energy service initiatives
by some of the Big Six, we remain concerned that these companies
see the delivery of the low carbon agenda in terms of big supply-side
projects in which only they can invest profitably. We think they
are neglecting low cost, innovative demand-side measures that
can reduce emissions quickly and without significant capital expenditure.
Although some opportunities have been pursued, these are
through a facilitated regulatory framework and not through genuine
commercial innovation. The Big Six talk of low carbon being at
the heart of their businesses but only take actions when there
are strong financial incentives, such as through the Cert and
the RO. The energy services market has also failed to take off,
and progress with smart metering remains fitful, with the companies
looking to government to mandate outcomes so they can in effect
recover their costs (either developmental or stranded).
At the same time, while individual supplier performance can
vary, the energy supply industry as a whole is not good at billing
its consumers and administering contracts. This situation prevails
despite the "super-complaint" made by Energywatch in
2004, and can unfortunately lead to heavy-handed treatment of
consumers who often correctly question erroneous bills. This treatment
also acts as a general inhibitor of consumers exercising their
right to access competitive markets. Mis-selling has also proved
an issue for some consumers and, once they suffer from it, the
experience can deter their participation in the competitive market-place.
5.4 Barriers to entry in retail markets
At the same time the costs of new entry, including accreditation,
are significant and timescales protracted, so existing players
have limited incentives to change how they approach the market
because there is no credible competition. More importantly their
influence is now such that they can also dictate the terms on
which they will change.
Recent years have a seen a number of new licences come forward
in the gas sector, especially in conjunction with the significant
development and expansion that has occurred in new gas infrastructure.
Many of these entrants are focussed on wholesale trading or are
financial traders, and it is noticeable that there has been virtually
no new entry into domestic supply.
The position in the electricity sector is much worse. Apart
from some traders few new parties have engaged in physical supply
at wholesale or retail level. As we noted in chapter 3, despite
the wholesale price collapse in from summer 2006, there has been
minimal new activity in the electricity supply markets despite
text book, supporting conditions.
There are a number of factors that have contributed to this,
including:
the complexity of the central trading arrangements
and the costs of entry. Registration, transfer and reconciliation
processes are all very complex, and dependent on complex systems
and extensive rules;
the problems we have identified arising from dysfunctionality
in the wholesale markets, especially electricity and their illiquidity,
and the risk of exposure to penal cash-out prices;
credit is a significant problem with multiple
calls across industry codes and trading structures; and
the economies of scale and the market power of
the Big Six, which have become mutually reinforcing.
There are particular issues that bite in the business markets.
The regulator has failed to tackle anti-competitive behaviour
by acting slowly to counter the blocking of a transfer by incumbents
reoffering on notice of a transfer. More importantly the regulator
has stood by as the all incumbent suppliers rewritten their supply
terms in ways designed to make customer switching much more difficult.
This combination of circumstances, combined with the great information
advantage the suppliers hold over their small business customers,
cedes significant market power to the incumbents who are able
to target their activity on potential switchers at a cost funded
by their wider customer base.
6. FAILINGS OF
REGULATORY OVERSIGHT
This chapter looks at the evolution of engagement by regulators
over the gas and electricity sector, focussing on responses by
Ofgem since the lifting of price controls on the supply markets.
6.1 Consolidation by default
The regionalised nature of household energy supply competition
is a direct function of the evolution of the Big Six through corporate
transactions rather than direct competition for consumers. None
of the transactions that created the Big Six has been properly
scrutinised by the competition authorities even though there has
been significant erosion in competition. For example no objections
were raised by Ofgem as the sectoral regulator when a scale playerTXUfailed
in 2002 and its 5.5 million consumers were acquired by E.ON UK.
More recently Scottish Power has been acquired by Iberdrola, and
rumours suggesting that further takeovers or mergers are in the
offing are commonplace within the sector.
The parliamentary Public Accounts Committee warned in 2003
that Ofgem should take seriously the risk that vertically integrated
companies may exploit their position, and Ofgem "should adapt
its competition analysis of the wholesale market and the retail
markets to reflect the new reality of the market".[178]
Despite this, there have been no studies of the implications of
this reintegration, either in terms of the retail market impacts
or the state of wholesale trading (or the interactions between
the two). The pervading feeling among consumer groups is that
our regulators have failed to act.
This position has given rise to a situation where large incumbent
players enjoy strong market power and where many consumers choose
not to switch possibly because of the time and cost issues. It
enables all suppliers to price tactically often at premium rates
in some areas for some domestic consumers in the full knowledge
that they will retain many of them. In business markets, particularly
for those consumers with non-standard load and/or multiple sites,
it is frequently difficult even after complex and costly approaches
to suppliers for consumers to see aggressive offers. Multi-site
consumers with non half hourly meters can find it particularly
difficult. This situation on the ground by no means reflects the
vigorous or effective competition that our policy makers and regulators
set out to achieve and whose existence they often invoke.
Against this backdrop levels of transparency and regulatory
reporting are minimal and inadequate.
6.2 Minimalist oversight of supply
Traditionally, as an important part of the process of setting
supply business price controls for each company, Ofgem exercised
a thoroughsome would say intrusivesupervisory role
over both gas and electricity supply businesses. It routinely
gathered information on costs, performance and returns for a period
of more than three years after the remaining supply franchises
were removed and after the sector was opened to full competition.
As part of this oversight process the regulator would routinely
check the allocation of wholesale purchase contracts against different
consumer classes to ensure that consumers with less choice were
not treated in a discriminatory manner.
Controversially the remaining price controls were lifted
in April 2002, as Ofgem believedthough many disagreedthat
retail markets were sufficiently competitive to permit this. But
areas identified as potentially problematic for consumers at the
time the decision to end price control, especially the treatment
of prepayment meters and consumers in Scotland with teleswitching,
have not been addressed properly although six years have since
passed.
Since 2002 Ofgem has produced occasional reviews on the state
of competition, which have tended to focus almost exclusively
on national switching levels. Its most recent analysis from June
2007 is on the domestic market and based on data as at end March
2007 and is nearly one year old. It has not issued any analysis
on the business markets since summer 2003.[179]
6.3 Defending the incumbents
Ofgem has periodically addressed aspects of market operations,
especially the wholesale price spikes that have been a recurring
feature of the British markets since October 2004. The main thrust
of its analysis has been:
to point to supply limitations and competitive
bottlenecks on the continent; and
to attribute price excursions to "market
sentiment".
In response to dissatisfaction among some politicians and
stakeholders over suppliers' resistance to curbing prices after
the collapse in oil prices from mid 2006, Ofgem maintained that
it was examining supplier behaviour but that competition was fundamentally
vigorous and effective. No hard analysis was presented to substantiate
these claims beyond generalised, high-level switching data.
On 8 February 2007 the regulator described British Gas decision
to cut prices in March that year as "the first shot in what
Ofgem expects will be the start of another battle for consumers"
It also went to some lengths to explain what it described as the
lag between wholesale and retail price falls as being helpful
to suppliers in delivering supply security.[180]
It also introduced the concept of "full cycle" costs,
which seemed to be short-hand term for allowing suppliers to over-recover
from consumers at times of lower wholesale prices.
At the time there was plenty of independent comment that
contradicted Ofgem's view, as the following examples illustrate:
"press reports of a price war among UK energy
suppliers are, in our view, misleading. While the industry no
doubt welcomes the publicity the price cuts actually announced
so far by Powergen [initial new online offers] and Npower are
the minimal reaction we would expect to see in response to Centrica's
new tariffs"; Citigroup comment 19 February 2007;
"in our view, the recent price cuts do not
constitute a price war. The magnitude of competitor reductions
across all tariffs will depend largely upon each company's forward
hedge position in wholesale gas and power, and the assumed desire
to repair retail margins, particularly in gas"; Merrill Lynch
comment 19 February 2007; and
"The reductions result in Npower being marginally
cheaper than British Gas (Centrica) on average, although in their
original franchise areas, we believe they will be marginally more
expensive. Although this has been trailed as an intensification
of a price war, we disagree. We see it as further evidence of
the disciplined nature of the market, given that Npower has moved
prices to almost in line with Centrica. We would expect others
to follow suit over the next few weeks"; UBS comment 19 February
2007.
And with the launch of its latest price probe inquiry on
21 February 2008 Alistair Buchanan, the chief executive of Ofgem,
said "We, of course, keep the market under constant surveillance
but to date we have seen no clear evidence that the market is
failing." Again there was no analysis presented in support
of these statements.
energywatch finds it extremely disconcerting that the industry
regulatorwhose primary duty is the protection of consumer
interestsshould be making the case for energy suppliers'
price movements. We also find it disingenuous for the regulator,
as it often does, to represent prices from the wholesale forward
curves as representative of suppliers costs when the leading players
are significantly integrated. It has itself highlighted the ability
of upstream electricity producers to earn windfall gains both
in the past and, more recently, going forward.[181]
In fact we would say its is mutually inconsistent for the regulator
to highlight this practice and then assert retail marketswhich
are the means of recovering these arbitrary costs from consumersare
properly competitive, as it has done consistently over the past
three months.
We fear there is a significant gap between the reality of
the market and the regulator's rhetoric.
6.4 Dangers of self-regulation
The industry left to its own devices has a very mixed record.
The scandal of mis-selling earlier in the decade saw many consumers
switched fraudulently and without their knowledge. Further many
consumers have found that as reflected in continuing high levels
of complaints the service they receive has deteriorated irrespective
of whether they have switched.
Regulatory moves to improve the situation for consumers have
been dominated by Energywatch, rather than Ofgem, as the following
examples illustrate:
we launched our "Stop now" campaign
in January 2002 to cut out mis-selling. This ultimately led to
an industry code of practice,[182]
which has substantially reduced the problem;
in June 2003, we were instrumental in creating
the consumer transfer programme, an energy industry-wide initiative
to improve the switching process for consumers;[183]
and
in 2003 we launched a "Better billing"[184]
campaign to highlight our growing exasperation with the harm such
practices were causing consumers, and minimal attempts to address
them prompted us to raise a billing super-complaint,[185]
which has led to the establishment of a billing ombudsman by the
industry.
Whilst we acknowledge that significant efforts have been
undertaken by the industry to address these issues once they have
been escalated, a common theme emerges which causes us great concern.
It is other organisations that have highlighted these consumer
issues and prompted the regulator to become involved in some action.
Moreover, and despite it's recently announced "Consumer first"
initiative, we detect in its activities a worrying tendency from
Ofgem to keep itself distant from real consumer issues and leave
them to others. There is also a worrying tendency for Ofgem to
put the onus on energy suppliers to resolve the issues once they
have become fixed in the media spotlight.
Even though Ofgem may believe it is practising "light
touch" regulation, we believe this disengagement is creating
poorer conditions for consumers and will leave significant legacy
issues once Energywatch is disbanded. Any arguments that the energy
ombudsman scheme is a good example of self-regulation are also,
in our opinion, undermined because it was action by an outside
body, in this case Energywatch raising the super-complaint, which
prompted the scheme to be developed.
Recent statements from the regulator have highlighted the
merits of increasing self-regulation within the industry, seemingly
as a consequence of managing its own costs following the self-imposition
of a RPI-X control on its costs. energywatch sees this as a worrying
tendency given Ofgem track record of reluctant engagement and
its readiness to act as an apologist for the Big Six.
7. CONCLUSIONS
There is now a growing body of evidence that shows competition
is less robust in Britain than generally asserted by regulators,
and this publication has synthesised some of the arguments and
evidence. This chapter summarises the main reasons why energywatch
firmly believes that energy markets are failing British consumers,
why the sectoral regulator is not responsive to these problems
and why there must be a referral to the Competition Commission.
Ultimately the enjoyment of higher gross switching rates means
little when there is no effective competition for many consumers
and where the Big Six can exert significant influence over the
prices they offer.
In this publication energywatch has identified a range of
significant deficiencies and questions that require urgent consideration.
We believe the various questions that follow should form the basis
of a referral to the Competition Commission under its Enterprise
Act powers.
7.1 Wholesale market failings
It is clear that the wholesale markets in both gas and electricity
share many of the characteristics identified by the European Commission
in its recent critique of Europe's energy markets. The British
market has a much longer record of liberalisation than virtually
all of our continental counter-parts, but this should not obscure
a critical appreciation of how our own wholesale markets are working.
Energywatch believes there is sufficient evidence to suggest
these markets, especially the wholesale electricity market, is
operating in a way that should deeply concern policy makers and
regulators. These concerns are amplified given that the Big Six
use the forward curve as the basis of pricing through the supply
chain.
We have identified several questions with regard to the operation
of the wholesale market that require further scrutiny, including:
have levels of vertical integration gone "too
far" and is the resulting industry structure materially undermining
competition in wholesale markets;
what characteristics define liquid wholesale markets
and what are the impediments to their realisation in Britain;
have independent generators and smaller suppliers
been forced out of the market or are they facing unfair access
as a result of the operation of the wholesale markets;
do suppliers with electricity generation or gas
production interests, or with long-term contracts with independent
generators and gas producers, have excessive information and control
over the market; and
does the operation of cash-out mechanisms in gas
and electricity aggravate problems of fair access, unnecessarily
increasing risk and barriers to entry?
7.2 Market linkages
The incumbents' recent argument that they individually have
been exposed to the same increases in costs derived from market
prices is incorrect, and access to in-house production and legacy
contracts mean that they are shielded from significant elements
of the recent wholesale cost increases. In some cases such as
new environmental costs these costs are being passed through ahead
of the point at which these costs fell on suppliers The practice
of basing tariff increases and contracts price offers on forward
prices has greatly exaggerated consumers' prices and resulted
in windfall profits being earned by upstream activities in both
generation and gas production, in addition to those already acknowledged
to arise from carbon trading.
We have identified several questions with regard to the interaction
of wholesale and retail markets that require further scrutiny,
including:
do the pricing policies of the Big Six enable
excessive production and generation profits to be passed through
the supply chain to de facto captive consumers through retail
tariffs;
what transfer prices are used in internal transactions
between upstream and downstream businesses;
to what extent are the Big Six exposed to market
prices;
to what extent are large suppliers misrepresenting
wholesale and environmental costs in their retail prices;
do suppliers have the ability to earn exaggerated
margins through their supply businesses as a consequence; and
what constitutes a reasonable level of margin
in retail markets?
7.3 Retail market failings
The retail markets are dominated by a small group of scale
utilities sustaining their businesses up the supply chain through
strong revenues from a predominantly regional consumer base that
has many de facto captive consumers. These players pursue essentially
similar pricing strategies in the knowledge that there is little
realistic threat of competitive entry. This characteristic is
illustrated by the similarity in pricing to key target consumers
despite different costs. It appears that the primary purpose of
the supply business of the Big Six suppliers is to provide a route
to market for their in-house generation.
Further competition in regional markets for gas and electricity
consumers is not as vigorous as national measures suggest, with
multiple switchers swelling the headline statistics. There is
still a lack of real choice for many consumers outside of dual
fuel, direct debit consumer propositions, especially for those
who are vulnerable or are on lower incomes, and they continue
to be disadvantaged in relative terms.
Innovation has been constrained and that the development
of advanced metering and energy services remains largely dormant.
Service is below standard, with billing proving obdurately inaccurate
sustaining high levels of disputes.
Barriers to market entry prevent any realistic competitive
threat emerging in the retail markets to a comfortable oligopoly,
especially in the domestic markets. Consumers are paying for that
lack of diversity through higher prices than necessary. There
is also a noticeable lack of differentiation between the large
suppliers. With all of them moving their prices typically within
a few weeks of each other and by similar degrees, the effect on
consumers eventually is very similarhigher bills.
We have identified several questions relating to the retail
markets that require further scrutiny, including:
how vigorous is competition at the local level
and by consumer type;
is there evidence of tacit collusion in price
setting;
how should effective retail competition be defined
and what criteria should be applied in assessing competition in
these markets;
why is new entry especially in electricity not
occurring on any scale despite volatile commodity prices;
do complex licensing, code requirements and centralised
trading arrangements effectively impose a barrier to entry; and
if so, how can they be simplified?
7.3 Failings in regulatory oversight
Throughout the turbulence of the last four years Ofgem has
been complacent at best and negligent at worst. It has consistently
refused to consider taking steps to investigate energy utility
prices and profits. It makes too many generalisations about the
state of competition based on the market for direct debit dual
fuel consumers and high-level gross switching data. It fails to
recognise prices across the board are artificially high. It relies
on the possibility of new entry to act as a constraint on abusive
behaviour by suppliers, but it oversees industry codes that in
energywatch's view constitute a significant barrier to entry in
the domestic markets. It has belatedly and reluctantly agreed
to conduct a price probe into supply markets but has done so grudgingly,
and still insists there is no evidence that markets are not working
properly.
energywatch welcomes the focus of the Business and Enterprise
Committee on the effectiveness of regulation of the gas and electricity
sector, and we believe in many important respects Ofgem's exercise
of its brief has been inadequate, aggravating the detriment caused
by the high and volatile consumer prices. We believe Ofgem is
failing in its duty to consumers because its views of the markets
it regulates are partial, and it is unwilling to engage in real
consumer issues. It's publication of analysis on the sector is
sporadic and narrowly focussed. Its developing role in Europe
is encouraging it in its selective view of the British market,
and its preoccupation with reform on the mainland is also increasing
the distraction of resources it deploys away from its key activity.
We would like to see a much more lucid focus by the regulator
on the pattern of competitive activity and its distribution among
different types of consumer.
Moreover, the regulator is actively promoting what it believes
to be a light touch regime and putting increasing emphasis on
the companies it oversees to regulate important aspects of their
own affairs, which can only worsen the consumer position as energy
suppliers control more and more of their own conduct.
We have identified several questions relating to the performance
of Ofgem with regard to oversight of electricity and gas markets,
including:
what on-going surveillance of these markets is
carried out;
what is an acceptable standard and how can market
reporting and transparency be improved; and
how can regulatory accountability with regard
to market surveillance and reporting be improved.
7.4 Remedies
There are various available policy remedies, all of which
we believe have differing degrees of merit. The principal ones
include:
disclosure of trading information: companies above
a defined size that have both production and supply interests
should be compelled to disclose and publish sufficiently disaggregated
information so that stakeholders can see what real trading is
occurring and at what prices. All the major suppliers should report
segmented financial and operating data about their electricity
and gas production and retailing operations to a robust and explicit
standard that Ofgem should develop, with clear information being
recorded on the returns made by individual activities, but especially
gas and electricity supply;
regulatory reporting requirements: there needs
to be greater regulatory scrutiny of purchase costs to ensure
that only costs which companies can demonstrate that they are
actually incurring should be capable of pass-through. This scrutiny
has been part of the British regulatory regime previously and
we think it should be reinstated;
mandatory trading: producers and generators could
be required to trade a defined level of out-put with non-affiliated
entities. An alternative mechanism would be to reimpose the self-supply
limit that used to be enforced by the generation licence;
simplifying market rules and entry requirements:
the current market rules are presently fragmented but very complex.
A fundamental make-over is required if smaller, low carbon operators
are to be able to access markets and consumers fairly;
supply price control: the reintroduction of direct
supply price controls to protect consumer interests should be
seen as a last, though possibly necessary, resort. We think the
scale of the current market failure is such that only a period
of direct supply price controls may be necessary to rebuild consumer
confidence in competitive energy markets; and
ultimately, if other measures are considered insufficient,
divestment of plant or function.
APPENDIX 1
PRICE MOVEMENTS BY THE BIG SIX SINCE 2004
(%) | Electricity
| Gas | Effective Date
|
E.ON UK | 0.0 | 3.1
| 6 Sep 2004 |
EDF Energy | 3.8 | 3.5
| 13 Sep 2004 |
British Gas | 9.4 | 12.4
| 20 Sep 2004 |
RWE Npower | 7.6 | 11.8
| 1 Oct 2004 |
Scottish Power | 8.0 | 11.8
| 4 Oct 2004 |
E.ON UK | 8.9 | 9.6
| 29 Nov 2004 |
EDF Energy | 5.4 | 8.1
| 17 Jan 2005 |
Scottish and Southern | 6.7
| 9.1 | 1 Mar 2005 |
Scottish Power | 0.0 | 2.6
| 1 Apr 2005 |
EDF Energy | 12.0 | 10.7
| 5 Aug 2005 |
E.ON UK | 11.9 | 7.2
| 31 Aug 2005 |
British Gas | 14.2 | 14.2
| 19 Sep 2005 |
Scottish Power | 12.0 | 5.0
| 17 Oct 2005 |
Scottish and Southern | 8.9
| 13.6 | 1 Jan 2006 |
RWE Npower | 12.0 | 13.7
| 1 Jan 2006 |
Scottish Power | 8.0 | 15.0
| 1 Mar 2006 |
British Gas | 22.0 | 22.0
| 1 Mar 2006 |
E.ON UK | 18.4 | 24.4
| 10 Mar 2006 |
EDF Energy | 4.7 | 14.7
| 13 Mar 2006 |
RWE Npower | 13.4 | 15.0
| 31 Mar 2006 |
Scottish and Southern | 9.4
| 16.5 | 1 May 2006 |
Scottish Power | 10.0 | 17.0
| 1 Jul 2006 |
EDF Energy | 8.0 | 19.0
| 31 Jul 2006 |
E.ON UK | 9.7 | 18.4
| 21 Aug 2006 |
British Gas | 9.4 | 12.4
| 1 Sep 2006 |
RWE Npower | 9.9 | 17.2
| 1 Oct 2006 |
Scottish and Southern | 9.4
| 12.2 | 1 Jan 2007 |
Scottish and Southern | -5.0
| -12.0 | 1 Mar 2007 |
British Gas | -11.0 | -17.0
| 12 Mar 2007 |
British Gas | -6.0 | -3.0
| 26 Apr 2007 |
RWE Npower | -3.0 | -16.0
| 30 Apr 2007 |
E.ON UK | -5.0 | -16.0
| 30 Apr 2007 |
EDF Energy | 0.0 | -10.6
| 15 Jun 2007 |
Scottish Power | -5.5 | -16.5
| 15 Jun 2007 |
RWE Npower | 12.7 | 17.2
| 4 Jan 2008 |
EDF Energy | 7.9 | 12.9
| 18 Jan 2008 |
British Gas | 15.0 | 15.0
| 18 Jan 2008 |
Scottish Power | 14.0 | 15.0
| 2 Feb 2008 |
E.ON UK | 9.7 | 15.0
| 8 Feb 2008 |
Scottish and Southern | 14.2
| 15.8 | 1 Apr 2008 |
| | |
|
APPENDIX 2
EXITS FROM THE LARGE GENERATION MARKET SINCE 2000
Plant type/name | MW
| Tech | Seller |
Purchaser | Date |
Sutton Bridge | 790 | gas
| Enron | EDF Energy | Mar 2000
|
Corby 2 | 350 | gas
| Dominion | Powergen | Sep 2000
|
Humber Power | 1,260 | gas
| Consortium | Centrica, Elf |
Jun 2001 |
Peterborough/Kings Lynn | 705
| gas | TXU | Centrica
| Aug 2001 |
Ferrybridge | 2,000 | coal
| Edison Mission | AEP | Oct 2001
|
Fiddlers Ferry | 2,000 | coal
| Edison Mission | AEP | Oct 2001
|
West Burton | 2,000 | coal
| TXU | EDF Energy | Nov 2001
|
Brigg | 240 | gas
| IVO Energy | Centrica | Jun 2002
|
Roosecote | 229 | gas
| Receivers (formerly owned by Lakeland Power)
| Centrica | May 2003 |
Barry | 240 | gas
| AES | Centrica | Jul 2003
|
Medway | 700 | gas
| AES/EDF | Scottish and Southern Energy
| Oct 2003 |
Fife | 120 | gas
| El Paso | Scottish and Southern Energy
| Feb 2004 |
Damhead Creek | 800 | gas
| Banks (formerly
owned by Entergy) |
Scottish Power | Jun 2004 |
Killingholme | 660 | gas
| Banks (formerly
owned by NRG) | Centrica
| Jun 2004 |
FFF | 4,000 | coal
| Banks (formerly
owned by AEP) | Scottish and Southern Energy
| Jul 2004 |
Shoreham | 200 | gas
| AEP | Scottish Power | Sep 2004
|
Enfield | 392 | gas
| NRG | E.ON UK | May 2005
|
Saltend | 1,200 | gas
| Calpine | International Power
| Jul 2005 |
Yarmouth | 420 | gas
| BP | RWE Npower | Oct 2005
|
Drax | 4,000 | coal
| Banks (formerly
owned by AES) | flotation
| Dec 2005 |
Teesside Power | 1,800 | gas
| Teesside Power Ltd | Gaz de France/Suez
| Feb 2008 |
| |
| | | |
APPENDIX 3
EXITS FROM THE SUPPLY MARKETS SINCE 2000
Supplier | Date
| Comment |
Independent Energy | 2000 |
Company failure with contracts procured from its administrator by npower.
|
Enron Direct | 2001 | Trade sale to Centrica after failure of parent company.
|
Amerada | 2002 | Supply operation acquired by TXU Europe.
|
Electricity Direct | 2002 |
Successful trade sale to Centrica. |
TXU Europe | 2002 | Company placed in administration; contracts acquired by Powergen.
|
Exxon Mobil | 2002 | Company's gas supply contracts acquired by TotalFinaElf.
|
Maverick Energy | 2003 |
Company placed in administration; contracts assumed by Atlantic Electric and Gas.
|
UK Electric Power | 2003 |
Company withdraws from market by refusing to renew contracts with customers.
|
Shell Gas Direct | 2003 |
Exit from the power market on commercial grounds by a leading supplier of gas to business customers.
|
Atlantic Electric and Gas | 2004
| Company placed in to administration ahead of sale of contracts to Scottish and Southern Energy.
|
BP Gas Marketing | 2004 |
Reported to be letting gas supply contracts lapse rather than renew.
|
Team Group | 2005 | Administration. Contributed to Utility Link failure. Customers to EDF Energy.
|
Egni | 2005 | Administration. Contributed to Utility Link failure.
|
Utilita | 2005 | Managed transfer of customers to EDF Energy.
|
Eledor | 2005 | Administrationlicence revoked. SOLR invoked with customers to Npower.
|
Reepham | 2005 | Administrationlicence revoked. SOLR invoked with customers to British Gas.
|
Utility Link | 2006 | Administrationlicence revoked. SOLR invoked with customers to EDF Energy.
|
Greenwich Energy | 2006 |
Administration. Customers to EDF Energy |
Zest 4 | 2006 | Administrationlicence revoked. SOLR invoked with customers to British Gas.
|
Telecom Plus | 2006 | RWE takes customers and acquires call option on 29% share of Telecom Plus.
|
April 2008
|
| |
143
First Energywatch brochure 2007. Back
144
The terms of reference also include the status of fuel poverty.
A separate discussion paper will address the deteriorating position
with regard to this. Back
145
British Gas (Centrica), EDF Energy, E.ON UK, RWE npower, Scottish
and Southern Energy and Scottish Power. Back
146
The new electricity trading arrangements in England and Wales,
Second report of session 2003-04, House of Commons Public Accounts
Committee (1 December 2003), page 11. Back
147
Financial Times, 1 February 2007. Back
148
The figures in these tables differ compared to Table 2.3 because
the data in that table is not annualised. Back
149
Where available the paper uses GB statistics. Otherwise UK data
has been given. Back
150
Eurostat data for domestic consumers. Back
151
Belgium, Germany, Spain, France, Ireland and Italy. Back
152
Eurostat data for business consumers. Back
153
Source: Office for National Statistics as reported by BBC News-http://news.bbc.co.uk/1/hi/business/4797419.stm Back
154
European Commission Competition DG, ENERGY SECTOR INQUIRY PRELIMINARY
REPORT, 16 February 2006. This can be accessed at http://ec.europa.eu/comm/competition/sectors/energy/inquiry/index.html. Back
155
Both gas and electricity markets in Britain have been designed
to provide incentives for participants to be in balance, meaning
they should endeavour to be fully contracted for their outputs
as a generator or consumption as a supplier. Any uncontracted
trades are subject to imbalance or "cash-out" charges,
and these tend to reflect the costs of short-term peaking energy,
which is expensive. During periods of high demand or supply uncertainty,
these cash-out prices can be several times the value of traded
prices for the underlying commodity. Back
156
European Commission's Preliminary report electricity (February
2006), page 113. Back
157
FSA report 2006. Back
158
FSA report 2007. Back
159
RWE fact book 2007. Back
160
www.leba.org.uk/ This organisation produces indices based on aggregated
trades for periods up to a week ahead reported by its five members. Back
161
Day-ahead traded volumes as a percentage of demand in 2006 were:
GB 8.5%,Netherlands 15.8%, Germany 16.6% and Nordpool 63%. The
data was presented at a cash-out review meeting in February 2007. Back
162
A typical week-day load shape, with equal base and peak hours,
is a crude proxy for the needs of smaller suppliers and a benchmark
product. For the 17 months from October 2003 to March 2005 the
four components required for a 1-year load shape 44 were traded
on the same day on 22 occasions; for the 2-year product this happened
on only 2 occasions and for the 3-year product not at all. Back
163
Global Insight report. Back
164
www.ergeg.org/portal/page/portal/ERGEG_HOME/ERGEG_PC/ARCHIVE1/GGP_Transparency Back
165
Centrica ceased publishing its weighted average supply costs for
gas and electricity effective from reporting its 2006 preliminary
results, removing one of the most important indicators in a sector
which is becoming progressively more opaque. Back
166
The spark spread is the theoretical net income of a gas-fired
power plant from selling a unit of electricity, having bought
the fuel required to produce this unit of electricity. All other
costs (operation and maintenance, capital and other financial
costs) must be covered from the spark spread. Back
167
Long-term interruptible (LTI) arrangements were marketed by the
then British Gas plc to power station developers in the early
to mid 1990s for supplies up to 15 years with prices formulas
linked to changes in energy prices and inflation. Back
168
Implications of the EU emissions trading scheme for the UK
power generation sector, a report to the Department of Trade
and Industry, IPA Energy (November 2005). Back
169
Ofgem press release, February 2008. Back
170
Scottish and Southern Energy will not, as their price rise came
into effect from 1 April. Back
171
Electricity data from Ofgem's domestic retail market report March
2007. Gas data from Table 2.5.1: Percentage of domestic gas consumers
by region by supplier type and Table 3.5.1: Percentage of domestic
gas consumers by region by supplier type for the first quarter
of 2007. Quarterly energy prices (December 2007). Back
172
Figures on retained market shares by historic incumbents are separately
provided for direct debit, standard credit and prepayment terms
but unfortunately not on an aggregated basis. We have derived
the single regional figures for gas and electricity shown in Figure
5:1 from this data. Also, unfortunately, the gas and electricity
supply regions reflect historic industry structures and are therefore
not contiguous. However, we believe there is enough cross-over
to make comparison between fuels valid and worthwhile. Back
173
The Berr figures for electricity tend to overstate the degree
of switching as they focus only on one licence, the "legacy
PES", rather than all the licences traded by the major players.
This is especially relevant to E.ON UK and RWE npower and using
Berr data rather than Ofgem can lead to a significant understatement
(up to 15% in some areas). For example, E.ON UK appears to add
all new household accounts to its East Midlands licence even if
they may be located in Eastern or the North West. Back
174
Duel fuel competition in the British energy retail markets,
Richard Green, then of University of Hull Business School, May
2005. Back
175
Ofgem press release (January 2008). Back
176
Energy business markets report. Back
177
ERA briefing note. Back
178
The new electricity trading arrangements in England and Wales,
Second report of session 2003-04, House of Commons Public Accounts
Committee (1 December 2003). Back
179
It requested views on the market in November 2005, but took no
tangible steps as a consequence subsequently. The earlier review
is Review of competition in the non-domestic gas and electricity
supply sectors. Initial findings (July 2003). Back
180
Ofgem press release (February 2007). Back
181
Ofgem press release (February 2008). Back
182
Energywatch press release (3 June 2003). Back
183
Energywatch press release (11 June 2003). Back
184
Energywatch press release (13 May 2003). Back
185
Energywatch Better billing referral (May 2005). Back
|