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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