Select Committee on Business and Enterprise Written Evidence


Memorandum submitted by Morgan Stanley & Co.

  Morgan Stanley & Co. International plc welcomes the opportunity to comment on behalf of itself and its affiliate Morgan Stanley Capital Group Inc., with regard to the Business Enterprise and Regulatory Reform (BERR) Investigation into Energy Prices, Fuel Poverty and the Structure of the Market, as well as Security of Supply. Morgan Stanley's commodity business is an active participant in the UK's electricity market and in other commodity markets worldwide. As a financial intermediator we facilitate access to the market for new entrants as well as providing risk management services to more established participants. This response reflects our activity in this capacity and the knowledge of the market gained. The focus of our comments relates to Energy Prices and the Structure of the Market. We should be grateful if you would treat this as a non-public, confidential response.

  The best protection against excessive costs to consumers is well-designed, transparent, liquid markets at both a wholesale and retail level. Markets allow entities with a competitive advantage to enter and compete in specific market segments without needing to be vertically integrated. Other specialist entities competitively provide other components or attributes that form the final bundled product to consumers. Thus consumers get a wide range of choice in both price and service. Reducing barriers to entry should thus be a core objective for regulators. Low barriers to entry are key attributes of an efficient market. An efficient market should have a diversity of participants and should not result in vertical integration.

  The most significant barrier to entry for new participants in the retail market is the cash-out mechanism, which is currently being reviewed by Ofgem. Retail power suppliers and generators will always have some level of imbalance which they cannot avoid because load cannot be predicted with complete certainty. Imbalance volumes will be a smaller percentage of the total power supplied for a larger portfolio, due its greater forecastability. Thus smaller players are disadvantaged by the current arrangements.

  There are two important issues in the cash-out mechanism. Firstly, the assignment of costs to participants does not follow the principle of cost assignment to cost causation. Cash-out charges should relate to the cost of energy imbalance, but they currently also include a large proportion of system balancing costs that should fall under BSUoS.

  The second, more significant issue is the highly punitive dual pricing structure. This strongly benefits larger, vertically integrated participants who have at least some ability to reduce imbalance charges for their combined portfolio via adjustments to the output from their generation assets. A single cash-out price, or a significantly less punitive spread between SBP and SSP for the first X MW of imbalance would reduce the imbalance cost burden on small suppliers and generators, thereby removing this barrier for new entrants.

  The overview above captures Morgan Stanley's views on the competitiveness of the retail and wholesale markets at this time. Listed below are answers to selected specific questions asked by BERR:

1.  Whether the current market structure encourages effective competition in the retail markets for gas and electricity.

  The core of the market structure is sound. However, early competitive pressures have naturally driven the market towards consolidation. After achieving this type of equilibrium state, it is not unnatural for companies to migrate towards more defensive positions whereby defending existing market share of supply points is more important than vigorous additional competition. The best market design to protect against such a state is to ensure that there are no institutionally supported barriers to entry or assessments of costs that are not related to cause. This maximizes opportunities for innovative, specialised market entrants to compete for any profit making opportunities that may exist. Morgan Stanley have outlined one barrier to entry that we believe needs addressing. There may be others.

2.  Whether there is effective competition in the wholesale markets for gas and electricity.

  There are a number of wholesale competitors. Some however are vertically integrated which harms wholesale competition. The harm comes primarily from the reality or perception of unfair advantage. We note that regulators in some jurisdictions forced divestiture and vertical disaggregation. Morgan Stanley does not believe this is necessary. A market design with low barriers to entry and a level playing field tends to drive vertical disaggregation. A primary barrier to wholesale market efficiency is the balancing market.

3.  The implications of growing consolidation in the energy market.

  Morgan Stanley observes that highly efficient and competitive markets can be dominated by a few large participants. Horizontal consolidation would be an expected outcome in such a market. However, significant vertical integration would not be an expected outcome. It would instead be a consequence of a market that is not fully competitive. Thus barriers to entry must be kept low so that small innovators can continue to bring improvements.

4.  The relationship between the wholesale and retail markets for electricity and gas.

  A wholesale market should service the interests of retailers. This is occurring and exemplary evidence can be seen. An example is Morgan Stanley's product offerings to small retailers. However as already noted, we and our clients are disadvantaged by the wholesale balancing market.

5.  The interaction between the UK and European energy markets.

  We believe there should be tight coupling between markets. If cross border capacity is explicitly auctioned, holders of capacity whether long term or short term, should be able to rely on the transmission system operator (TSO) to optimize flows on their capacity on their behalf, with capacity holders keeping the resulting congestion revenues. Only the TSO has the real-time information to ensure that all flows are easing and not increasing congestion.

6.  The effectiveness of regulatory oversight of the energy market.

7.  Progress in reducing fuel poverty and the appropriate policy instruments for doing so.

  Morgan Stanley views reduction of fuel poverty as a societal goal, not directly related to energy markets. As such, remedies should be provided and funded by society generally, not via mandates or restrictions on energy markets. However, if energy markets are vigorously competitive, prices will be fully cost-reflective. The resulting level of fuel poverty will be minimised relative to levels that may otherwise be experienced if the market is not fully competitive. Therefore, actions taken to ensure vigorously competitive energy markets have the additional benefit of reducing fuel poverty.

1 April 2008





 
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