House of Commons - Business and Enterprise

Select Committee on Business and Enterprise Written Evidence

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 view—which we continue to hold—that 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 same—our 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);

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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 markets—the self-proclaimed most competitive energy markets in Europe—have 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 2005-08—STANDARD 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:

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— 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:

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— 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 identified—which they considered widespread on mainland Europe—are 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 markets—normally 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 concentration—the 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;

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— market integration—all 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;

— transparency—energywatch-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 formation—wholesale 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;

— environment—some 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 supply—small 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

— innovation—small 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 consumption—some 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 suppliers—and 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

— value added tax (VAT).

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 electricity—especially the most recent and those for imported gas—may 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 purchases—for periods running from days to low numbers of years—of 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 supplier—or rather in many cases the company that acquired that organisation—and 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 REGION—MARCH 2007

Source: Electricity—Ofgem March 2007. Gas—Berr 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 HHIs—APRIL 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 others—effectively the rest but especially the fuel poor, other vulnerable consumers and those with prepayment meters—there 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 2007—the latest period for which figures are available—to 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 2008—GB AVERAGE, DIRECT DEBIT TERMS FOR A MEDIUM USER

Dual Fuel—Medium 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 for—and therefore welcomes—the 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:

177

— 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 player—TXU—failed 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 thorough—some would say intrusive—supervisory 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 believed—though many disagreed—that 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 regulator—whose primary duty is the protection of consumer interests—should 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 markets—which are the means of recovering these arbitrary costs from consumers—are 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:

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 similar—higher 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	Administration—licence revoked. SOLR invoked with customers to Npower.
Reepham	2005	Administration—licence revoked. SOLR invoked with customers to British Gas.
Utility Link	2006	Administration—licence revoked. SOLR invoked with customers to EDF Energy.
Greenwich Energy	2006	Administration. Customers to EDF Energy
Zest 4	2006	Administration—licence 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