Memorandum submitted by Professor Dieter
Helm, Professor of Energy Policy, University of Oxford
1. This memorandum addresses possible anti-competitive
behaviour in the UK electricity and gas markets, the relevant
evidence, and the extent to which the structure of the market
distorts competition.
THE VARIOUS
CLAIMS MADE
BY THE
TREASURY, OFGEM
AND OTHERS
2. Recent large increases in retail electricity
and gas prices have given rise to claims that the energy markets
are not sufficiently competitive. It has further been claimed
by Ofgem that the electricity companies have benefited from a
windfall of some £9 billion as a result of the grandfathering
of the EU Emissions Trading Scheme (EU ETS) permits for the second
phase, 2008-12. Ofgem has recommended that a windfall tax for
this amount be levied on the electricity companies and that the
revenues be used to cross-subsidise the fuel poor. The Treasury,
through a series of "star chamber" meetings with the
industry, has conflated these issues further, by arguing that,
because of the alleged excess profits (whether from the permit
grandfathering or otherwise), the main suppliers should cross-subsidise
the fuel poor "voluntarily" against the threat of a
windfall tax.
3. These claims confuse three separate questions:
(i) whether there is anti-competitive behaviour?
(ii) whether there is a windfall, and whether
this amounts to £9 billion?
(iii) whether in a competitive market, cross-subsidies
are appropriate from one group of customers to another?
EVIDENCE ON
ANTI-COMPETITIVE
BEHAVIOUR
4. The main claims that have been made about
anti-competitive behaviour have not been substantiated by empirical
evidence. Ofgem claims that this is because there is no evidence.
The industry claims that retail prices have increased because
wholesale prices have risen (and by more than retail prices),
and that there is customer switching between suppliers.
5. In the NETA market structures, which
went live from 2000, the evidence is extremely hard to assess
from the outside. Unlike the Pool, which NETA replaced, generators
and suppliers are free to contract as they choose, whereas the
Pool required all significant electricity to be sold into the
Pool and anyone could purchase supplies at the Pool price. The
Pool was compulsory, transparent and (very) liquid. The introduction
of NETA encouraged vertical integration, and pluralised the contracting
strategies of the participants. As a result, vertical integration
became highly desirable, creating physical hedges for the integrated
companies, and leaving generation-only and supplier-only companies
at a competitive disadvantage. NETA has proved a major barrier
to entry by both merchant generators and supply-only businesses.
It is therefore not surprising that there is no significant entry
up or downstream since its introduction.
6. NETA also made consolidation within the
vertically integrated players attractive, and indeed the result
has been that a small number of companies now dominate the market.
7. It is impossible from the outside to
establish whether the result has been consistent with the behaviour
of a competitive market. In the absence of entry, the incumbents
could be engaged in an intensely competitive battle for market
share—and, in the key test for a competitive market, prices
could be related to costs.
8. The problem for external observers is
that the costs upon which prices are based vary, and in a non-transparent
way. In particular, it is not sufficient to claim that prices
in the wholesale market are tracked by retail prices. The reasons
include: the determination of wholesale prices and the influence
on those prices of the vertically integrated players; the impact
of different fuel mixes on the costs of particular players; and
the extent of physical hedges.
9. It is therefore not possible for Ofgem
to claim that the market is competitive (or not)—as, for
example, in response to the Chancellor of the Exchequer's questioning
in January 2008 (and it is surprising that Ofgem then announced
that, although it believed the market was competitive, nevertheless
due to "public pressure" it would conduct its own wide-ranging
inquiry). In order to make an informed judgement, there will need
to be close scrutiny of the contracts, costs and their relation
to prices.
THE WINDFALL
CLAIM AND
THE EU ETS
10. Ofgem claims that the generators have
made a windfall profit of some £9 billion from the grandfathering
of permits for the EU ETS phase two, and that these ought to be
taxed, with the proceeds given to the fuel poor. This is extremely
simplistic. Whilst there was a case for an ex ante auction, the
arguments for an ex post windfall tax are very different. There
are very considerable implications for the market. It is very
surprising that Ofgem claims that it knows what the generators
would have paid had there been an auction (and the example of
the 3G licences for telecoms indicates the possible scale of error
in such predictions). It is also very important to bear in mind
the impact on balance sheets of such a tax and the particular
implications for the smaller generation-only players, whose competitive
role would probably be significantly diminished by an ex post
windfall tax.
11. It is also extremely surprising that
Ofgem and the Treasury chose to conflate the windfall tax with
the fuel poor, given that there are generators without retail
customers, and the climate change problem is distinct from the
fuel poverty concerns.
CROSS-SUBSIDIES
AND COMPETITIVE
MARKETS
12. The Treasury's intervention has gone
further in its conflation of different issues. The Chancellor's
initial concern was with the degree of competition, but then the
Treasury used "star chamber" meetings to try to get
the main vertically integrated players to cross-subsidise from
the bulk of their customers to the fuel poor. Such cross-subsidies
are patently inconsistent with competition, so either the Treasury
wanted to exploit the claimed (excess) revenues from the claimed
anti-competitive behaviour for the benefit of achieving a separate
policy goal, or it wanted to handicap the incumbents against entrants.
13. Fuel poverty remains a serious issue—which
might get worse if incomes fall and/or prices rise further. There
are at least three possible permanent solutions: a levy on all
suppliers, a levy on distribution, or social security spending.
The latter is the least distorting (and the most appropriate).
Distribution is a monopoly, and hence distribution customers can
be in effect be taxed for this purpose. Supply is supposed to
be competitive, and therefore only if a levy is applied across
all suppliers on an equal weighting can it be consistent (roughly)
with maintaining competition. The (political) trouble with the
explicit supply or distribution levy is that they both make transparent
that some customers are subsidising others—a redistribution
policy that is normally regarded as a function of the tax and
social security systems.
TOWARDS A
MORE COMPETITIVE
MARKET
14. The current market design—NETA—lies
at the heart of competition problems in the UK energy markets.
In the NETA market, the combination of a lack of transparency
and the competitive advantages under this market form for vertically
integrated large companies tend to limit competition in effect
to the main players. This was predicted at the time, and it was
not surprising that these large players were enthusiastic advocates
of the replacement of the Pool by NETA. Given the close involvement
and advocacy of NETA by Ofgem, it is unlikely that it will be
willing to take a close enough look at this market design.
15. Serious consideration may need to be
given as to how to place supplier-only businesses on a level field
with vertically integrated players, and NETA needs appropriate
reform in this regard.
16. NETA also replaced the capacity market.
Whilst the Pool-based capacity market was seriously flawed, the
elimination of this market has further reduced the scope for merchant
entry into generation. A capacity market, with auctioned slots,
would provide a more even field for entrants.
CONCLUSIONS
17. The main conclusions are:
| (i) | the voluntary nature of the NETA market makes it impossible to externally establish whether there is evidence of anti-competitive behaviour. This requires detailed scrutiny of the costs of generators, to see whether these are closely related to prices. It is not apparent that Ofgem is in a position to know the answer at this stage;
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| (ii) | the relationship between wholesale and retail prices is not a sufficient test of competition;
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| (iii) | the case for an ex post windfall tax is very weak;
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| (iv) | Ofgem is not in a position to know what generators would have paid ex ante in a permits auction for phase two of the EU ETS;
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| (v) | the relationship between the grandfathering of permits and fuel poverty is at best tenuous—especially given that not all generators are vertically integrated;
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| (vi) | the Treasury's attempt to "persuade" vertically integrated companies to "voluntarily" cross-subsidise the fuel poor has been very unfortunate;
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| (vii) | fuel poverty requires a permanent solution which does not distort competition—cross-subsidies are not consistent with a competitive market;
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| (viii) | NETA is a major cause of market distortions and it acts as a significant barrier to non-vertically integrated entrants; in this regard it is anti-competitive;
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| (ix) | the absence of a capacity market under NETA further reduces the scope for new entry.
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31 March 2008
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