Memorandum submitted by the University
of Greenwich
ARE THE CONSUMER PRICE INCREASES FOR ELECTRICITY
IMPOSED IN JANUARY 2008 JUSTIFIED?
SUMMARY
This paper examines whether increases to published
wholesale prices justify the retail electricity price increases
imposed on residential consumers in January 2008. The study is
based on analysis of two questions: Is the reported wholesale
price a reliable indicator of the cost electricity retailers are
paying to buy power; and is the corporate structure of the British
electricity sector competitive?
Detailed analysis of prices shows that even
in the period 1990-2002, when prices for electricity were falling
in real terms, the wholesale electricity market was not working
well. Large cost reductions experienced by the generating companies
were not passed on to consumers as would have been expected to
occur if the wholesale electricity market had been an efficient
one. Experience since 2002 has demonstrated that the retail electricity
market is also not efficient and has allowed the electricity companies
to increase prices to residential consumers without convincing
justification and not pass on cost reductions. So the current
problem is not an isolated one in an otherwise successful system.
The assertion by the six electricity retail
companies that the large price rises for electricity imposed in
the first quarter of 2008 are justified by movements to the wholesale
market price for electricity is not supported by the evidence
they have given. The liquidity of the visible wholesale market
is negligible and the six companies buy nearly all their own power
from their own power stations or from independent power producers
under long-term contracts. The connection between the cost of
these purchases from their own sources and under long-term contracts,
and the published price in the spot market is weak. There are
strong suspicions that this is not the first time the companies
have manipulated prices to their advantage. In 2002, the wholesale
electricity price fell by 40% but none of this was passed on to
residential consumers. In 2005-06, the companies increased their
prices by 50% or more citing high wholesale prices, but when wholesale
prices fell in 2006, the price reductions were minimal.
Residential consumers already face a near impossible
task in trying to get the best deal for their power purchases.
They have to choose a supplier knowing only the current relative
prices, which in a volatile market could easily have changed even
before the switch to a new supplier has been completed. They have
to compete with large users to buy power and the retailers have
a history of systematically allocating their cheapest power purchases
to large users, presumably because of their stronger negotiating
power. The companies also discriminate against poorer consumers,
offering much lower prices to those that can afford to pay by
direct debit and who have access to, and are confident with the
internet. Pre-payment meter and standard credit (quarterly variable
bills) consumers might pay a third more than direct debit consumers.
The companies have provided no convincing evidence that this price
differential is justified by real cost differences.
The structure of the electricity industry has
become significantly less competitive and more concentrated in
the past decade, with the implicit approval and sometimes at the
instigation of both the government and the regulatory authority,
Ofgem. Further changes are likely that will make the situation
worse. In the case of the likely takeover of British Energy, which
will remove the main independent power producer, the change was
at least in part prompted by the government itself. This reduction
in competition will give consumers even less confidence that prices
are being set competitively by the market. It will leave residential
consumers even more vulnerable to the market power of the oligopoly
of a handful of European companies that increasingly dominate
UK as well as European energy markets.
Solutions to these problems are not easy. When
confronted with such serious market failures, it is tempting to
recommend pro-competition measures, such as breaking up the companies,
forcing greater use of visible spot markets and reducing the extent
of integration of generation and supply. However, the result of
such measures could be to jeopardise security of supply if, as
seems likely, independent generation companies would profit more
from power shortages than from investing in new capacity.
The regulator, Ofgem, has a poor record. Dubious
price movements in 2002, 2004-05, 2006 passed with no serious
investigation by them and their response to the latest price rises
was belated. There must be suspicions that it was only prompted
by public outrage and the announcement of the BERR Select Committee
investigation. Ofgem's announcement of its inquiry gives concern
that Ofgem will be looking to shift blame elsewhere. It states:
"We are concerned about the increased volatility of wholesale
prices and we want to investigate how European and other global
energy market developments are affecting energy bills in Britain".
Fundamental issues such as the efficiency of the British wholesale
market and the corporate structure in Britain are nowhere mentioned.
Ofgem has also consistently failed to tackle the issue, long recognised,
of price discrimination amongst residential consumers which results
in pre-payment and standard credit consumers paying far more than
direct debit consumers.
A more impartial investigation than can be carried
out by Ofgem is needed and the Competition Commission seems the
most appropriate body to carry out such an investigation. The
issues it would need to examine are:
— Do movements in the price actually
paid for power by retailers justify the January 2008 price increases?
— What if any is the relationship between
the published spot price for electricity and the price paid by
retailers for power?
— Do cost differences justify the price
differences between the tariffs offered to pre-payment meter and
standard credit consumers, and to consumers paying by direct debit?
— Are residential consumers paying
disproportionately more for their power than large industrial
consumers?
— What are the costs of switching by
residential consumers and, if as seems likely they are high, can
these costs be reduced to more affordable levels?
— Is the structure of the electricity
market competitive and, in particular, would the takeover of British
Energy by one of the existing retailers lead to serious competition
issues?
If the problems identified cannot be remedied
by changes to the market, a return to a more strictly regulated
system of tariffs may be necessary.
The problem of the ineffectiveness of Ofgem
is a serious one and needs to be addressed separately. There must
be doubts, given its role in designing the wholesale market and
presiding over the corporate changes in the industry, whether
it is now too compromised to carry out its primary duty of protecting
the interests of consumers. A more comprehensive reform of regulation
may be required.
1. INTRODUCTION
In January 2008, five of the six electricity
retail companies supplying residential consumers in Great Britain
increased their electricity prices by up to 15% (see Table 1).
The sixth supplier, Scottish & Southern Energy pledged not
to increase its prices before the end on March 2008 but on 20
March, it announced its prices would rise by about 14.2% from
1 April 2008.
It is estimated that these price rises will
mean that 4.5 million households in Britain, about 20% of the
population, now suffer from "fuel poverty", they pay
more than 10% of their household income on energy purchases, compared
to about 2.5 million three years ago.
The companies try to justify the price increases
by claiming that the wholesale prices of electricity and gas,
which accounts for about a third of electricity generation and
therefore has an impact on electricity prices, had risen sharply.
This paper examines whether increases to published wholesale prices
do justify these retail price increases. The study is based on
analysis of two questions: Is the reported wholesale price a reliable
indicator of the cost electricity retailers are paying to buy
power; and is the corporate structure of the British electricity
sector competitive?
Table 1
ENERGY RETAIL PRICE INCREASES FOR RESIDENTIAL
CONSUMERS
| Company | Date
| Electricity (%) | Gas (%)
|
| RWE (Npower) | 04.01.08 |
12.7 | 17.2 |
| EDF | 15.01.08 | 7.9
| 12.9 |
| British Gas | 18.01.08 |
15.0 | 15.0 |
| Iberdrola (Scottish Power) | 01.02.08
| 14.0 | 15.0 |
| E.ON (Powergen) | 07.02.08 |
9.7 | 15.0 |
| Scottish & Southern Energy | 20.03.08
| 14.2 | 15.8 |
| Average | | 12.3
| 15.1 |
Source: Press reports
2. HOW ELECTRICITY
PRICES ARE
SET
In order to understand movements in electricity prices, it
is necessary to examine the four main elements that make up an
electricity bill. For price comparisons, taxes should be excluded.
This is especially important for international comparisons because
the tax rate varies from country to country and comparing prices
including taxes would give a distorted picture of the relative
costs from country to country.
2.1 Components of an electricity bill
Since the privatisation of electricity in Britain in 1990,
the four main components of electricity bills have been calculated
by different methods (see Table 2). These four components are:
wholesale electricity purchase price, supply cost (meter reading
and billing etc), transmission (use of the high voltage transmission
network) and distribution (use of the low voltage distribution
network and purchase and maintenance of the meter). The wholesale
price should be set by the market. From 1998, when residential
consumers were allowed to choose their retail supplier, the supply
price, which had previously been set by the regulator, should
also be set by the market. Transmission and distribution are monopolies
and the price for these elements is set by the regulator and,
for the same service, will be the same for all generators and
retailers.
Table 2
ELEMENTS OF A RESIDENTIAL CONSUMER'S ELECTRICITY BILL—%
(EXCLUDING SUBSIDIES)
| Price setting
| 1991 | 2008 |
| Generation (wholesale price) | Market
| 54 (60) | 69 (75) |
| Supply cost | 1991, Regulated monopoly. 2008, market
| 6 (7) | |
| Distribution (inc meter) | Regulated monopoly
| 25 (28) | 18 (20) |
| Transmission | Regulated monopoly
| 5 (6) | 4 (4) |
| Nuclear subsidy/Environment | Subsidy/levy
| 10 | 8 |
| Total | | 100 (100)
| 100 (100) |
Source: Offer and Ofgem
| | |
| |
| |
There have been a number of generally smaller elements. From
1990-96, 10% of every electricity bill was paid essentially as
a subsidy (the Fossil Fuel Levy, FFL) to the nuclear industry.[397]
Now, about 8% of the average bill is used to pay for energy efficiency
measures including the Carbon Emissions Reduction Target (CERT).
For residential consumers, if we strip away these additional
costs leaving just wholesale, supply, distribution and transmission,
we can see that the monopoly elements (transmission and distribution)
have fallen as a percentage of the bill from 34% in 1991, to 24%
in 2008. Generation and retail combined have increased from 67%
to 75%. Ofgem no longer estimates separately generation and supply
costs. It provides a figure of 66% (75% if we exclude VAT and
environment subsidies) that covers "energy, supply costs
and margin". When Ofgem last estimated separately the supply
cost in 2005, the figure it gave was 35% of the total bill. If
the price retailers pay for electricity (the wholesale price)
has increased significantly and the supply cost has not changed,
the supply cost, as a percentage of the overall bill would have
fallen somewhat since 2005.
In practice, it is difficult to know how Ofgem can estimate
the supply cost as Ofgem, as we will argue later, has no knowledge
of the price retail companies pay for their wholesale supplies,
so it would seem difficult for Ofgem to split up wholesale and
supply. In addition, Ofgem has moved a small number of costs that
were allocated to distribution in 1991 to supply so the 1991 figures
are not strictly comparable with current prices. Nevertheless,
it is clear that the supply cost has increased substantially since
1991. Various authors have tried to breakdown the elements of
the bill more precisely, especially the supply element (see Annex
1).
2.2 Price movements up to 2002
The rapid movements in prices from 2004 onwards came on top
of a period following privatisation in 1990 up to 2002 when prices
were relatively stable falling slowly in real terms. Household
electricity prices fell in real terms by about 25%. It is widely
assumed that these price reductions resulted from the impact of
competition in the wholesale and retail markets and from the improved
efficiency of private companies compared to nationalised companies.
In fact, these factors had little or nothing to do with the price
reductions. It can be shown that there were two main components
to the price reductions (Thomas, 2006): the removal of the FFL
in 1996 (which raised about £1 billion per year), which reduced
prices immediately by 10%; and reductions in the cost of the monopoly
elements, which halved in that period.
Given the collapse of British Energy in 2002 and the government's
rescue package which will cost tax-payers in the order of £12
billion,[398] it is
far from clear that the removal of the nuclear subsidy was ultimately
anything more than a shift of costs from electricity consumers
to taxpayers.
The dramatic reductions in the cost of transmission and distribution
came not from improvements in efficiency, but essentially because
the electricity assets were privatised for about a third of their
asset value (Thomas, 2004). The prices for these services are
set by allowing the companies a given rate of return on the value
of the assets they own. By selling the companies for only a small
fraction of their asset value, much of the value of pre-privatisation
assets was essentially written off and as a result, prices fell
sharply. The reductions will be temporary and prices will tend
to rise again as the written-down pre-privatisation equipment
is replaced at full market cost. The price reductions were effectively
paid for by taxpayers because assets they owned were sold for
below their value.
The price of generation was largely unchanged in the period
1990-99. This is hard to justify given that, like the transmission
and distribution assets, the power stations were sold for about
a third of their asset value and the real price generators paid
for coal and gas fell by 40% or more. These cost reductions appear
to have been retained partly as extra profits for the privatised
companies and partly passed on only to industrial consumers.
So even in the period 1990-2002, when the public, understandably,
believed that privatisation was working through the impact of
competitive markets and the superior efficiency of privately owned
companies, the reality was different. Markets were not working
well and there was no strong evidence that the privately owned
companies were more efficient than the nationalised companies.
2.3 Price movements from 2004-07
The price increases in the first quarter of 2008 come on
top of very steep price increases imposed by electricity retailers
from 2004-06 (see Table 3).[399]
Like the 2008 price increases, the companies tried to justify
them by claiming large increases in wholesale prices. From mid-2006,
wholesale prices fell but price reductions followed only slowly
(see Table 4) and, except for British Gas, these reductions were
more than wiped out by the price increases of 2008. On average,
electricity prices have increased by over 60% since the beginning
of 2004.
Table 3
PRICE RISES (%) IMPOSED BY UK ENERGY SUPPLIERS FROM JANUARY
2004 TO DECEMBER 2006 (mm/yy)
Company | 1
| 2 | 3 | 4
| 5 | 6 | Total
|
| B Gas | 9.4 (08/04) | 14.2 (09/05)
| 22 (02/06) | 9.4 (07/06) |
| | 66.7 |
| EDF | 6.7 (02/04) | 3.8 (08/04)
| 5.4 (01/05) | 10.7 (07/05) |
4.7 (02/06) | 8.0 (07/06) | 46.0
|
| RWE (NPower) | 5.8 (01/04) |
7.6 (09/04) | 13.6 (11/05) | 13.4 (03/06)
| 9.9 (09/06) | | 61.2
|
| E.ON (Powergen) | 6.9 (01/04)
| 8.9 (11/04) | 7.2 (07/05) |
18.4 (02/06) | 9.7 (08/06) |
| 62.1 |
Scottish Power
(Iberdrola) | 9.0 (09/04)
| 5.0-8.0 (10/05) | 8.0 (02/06)
| 10.0 (06/06) | |
| 36.0-39.9 |
Scottish & Southern
Energy | 4.0 (06/04)
| 6.7 (02/05) | 8.9-12.0 (11/05)
| 9.4 (03/06) | |
| 32.2-36.0 |
Source: Author's research
Notes
1. Dates shown are when the price rise was announced.
2. Scottish Power's and Scottish & Southern Energy's gas
and electricity price increases have varied according to the region
(whether it was their former home region) and method of payment.
Table 4
PRICE REDUCTIONS (%) IMPOSED BY UK ENERGY SUPPLIERS FROM
JANUARY TO DECEMBER 2007 (m/y)
| |
| Total price change
1/04-12/07 |
Total price change
1/04-2/08 |
| B Gas | 11.0 (2/7) | 6.0 (4/7)
| 39.5 | 60.4 |
| EDF | | |
46.0 | 57.5 |
| RWE (NPower) | 3.0 (2/7) |
| 56.3 | 76.2 |
| E.ON (Powergen) | 5.0 (2/7)
| | 54.0 | 68.9
|
| Scottish Power (Iberdrola) | 5.5 (5/7)
| | 28.5-32.2 | 46.5-50.7
|
| Scottish & Southern Energy | 5.0 (4/7)
| | 30.6-34.2 | 49.1-53.3
|
Source: Author's research
| | | |
|
3. CHOICE OF
ELECTRICITY SUPPLIER
FOR RESIDENTIAL
CONSUMERS
3.1 Special features of electricity
Intuitively, most people would assume that being supplied
by a competitive market will inevitably be preferable to being
supplied by a monopoly supplier. However, a number of factors
in combination mean that choosing an electricity supplier is a
very different and far more difficult choice than most other consumer
decisions they have to take. This may mean that consumers would
be better off being supplied by a well-regulated monopoly. These
factors include:
— Electricity is a standard product.
— Consumers must commit to buy a product without
knowing the price they will pay.
— Residential consumers are in competition with
large consumers to get the best deal from the retailers.
— In a competitive market, retailers will target
the most profitable customers; they cannot be given social obligations
without compromising the efficiency of the market.
3.1.1 Electricity is a standard product
Electricity is an entirely standard product. Changing supplier
cannot give the consumer "better" or more reliable electricity.
Billing should be an entirely routine business (unfortunately,
it appears not to be given the large number of complaints) so
service quality should not be a factor and consumers should only
have price by which to judge the different offers.
3.1.2 Consumers must commit to buy a product without knowing
the price
When consumers are investigating the prices offered, all
they have to go on is the current price (assuming the price comparison
sites are up-to-date). Given that most consumers are unlikely
to want to go through the process of establishing which company
is the cheapest and then switching supplier (a process that can
be very time-consuming and frustrating if things go wrong) more
than, say, once every two to three years, the chances that relative
prices will remain the same over that period are negligible. In
today's volatile price climate, it is not unlikely that relative
prices will have changed before the switch is completed and the
consumer will not even start with the cheapest deal. Anyone who
finds that large savings are to be made simply by switching supplier
(not changing payment method) is likely to be with a company that
has just raised its prices and the cheap company will be one just
about to increase its prices. There is also evidence that while
consumers that switch are generally attempting to move to the
cheapest company, they are often not successful. In a detailed
behavioural study, Waddams-Price (2004) found that, amongst a
sample of about 400 consumers who switched supplier, 42% of those
switching ended up paying more, 14% were paying the same, while
only 44% actually made savings. These percentages were calculated
based on the time the choice was made, not when the switch was
completed.
3.1.3 Residential consumers are in competition with large
consumers
In a market, the best prices go to buyers with the most buying
power. Unlike most products, residential consumers will have to
compete with very large users, eg, aluminium smelters and chemical
works with annual bills of millions of pounds, to buy power. Residential
consumers do not have anything like the buying power or expertise
of such companies, which can employ specialists to negotiate the
price they pay.
Now that electricity retail is a free market for all consumers,
the regulator has no knowledge of the wholesale price retailers
buy their power at. Large consumers buy their power on confidential
contracts, the details of which are only known to the two parties,
so it is difficult to provide current evidence for the existence
of the likely distortions noted above arising from the buying
power of large companies.
However, in 1997, the regulator, then Offer, published evidence
that the retailers had systematically allocated all their cheapest
power to large consumers. The large consumers were then able to
choose their electricity supplier, while residential consumers
still remained captive to their local retailer. This meant that
the generation element of a residential consumer's bill was about
30% higher than that of a large consumer (Thomas, 2006). While
the retail, distribution and transmission elements of the bill
for a large consumer are legitimately lower for a large consumer
than for a residential consumer, it costs no more to generate
a kWh for a residential consumer than for an aluminium smelter.
The electricity retail companies were simply taking advantage
of the inability of residential consumers to switch.
Offer did nothing about this abuse, assuming, naively, that
the introduction of retail competition would mean that retail
companies would not be able sustain this unfair allocation of
costs. In fact, the evidence is that introducing retail competition
allowed retail companies to increase the differential between
the generation price they charged large consumers and the price
they charged residential consumers. From 1999-2002, the price
large consumers paid for generation fell by 22% while the price
paid by residential consumers actually increased by 5% (Power
UK 2002), so opening up the market to competition actually exposed
residential consumers to greater exploitation. In this period,
as in 2007, large price reductions in the wholesale market were
not passed on to residential consumers.
The National Audit Office (NAO, 2003) in an investigation
into NETA [New Electricity Trading Arrangements, the then name
for the wholesale market] found:[400]
"Prices paid by industrial and commercial customers have
fallen sharply since NETA was implemented. Consumers who switch
supplier can see substantial reductions. However, prices that
domestic consumers pay for electricity have not fallen much since
NETA was implemented, although they have fallen broadly in line
with the trend in suppliers' overall costs since 1998. The prices
that industrial and commercial consumers pay for electricity have
fallen by 18% since the start of NETA, and by 30% since April
1998. Prices for domestic consumers have fallen little since the
start of NETA but by 8-17% since April 1998, reflecting the much
higher costs of supplying domestic consumers which have been rising
due to new environmental costs and the substantial costs of processing
changes of supplier".
3.1.4 In a market, companies will target the most profitable
customers
There is much clearer evidence of discrimination between
different classes of consumer within the residential sector. Specifically,
there is a large and consistent difference between the prices
charged to consumers on pre-payment meters and standard credit
terms (quarterly bills that are settled when they are issued)
compared to the prices charged to those paying by monthly direct
debit. There is no evidence that these price differentials reflect
differences in costs and there must be strong suspicions that
companies are simply targeting the more profitable consumers.
Pre-payment meters (PPMs) have played a key role in dealing
with low-income consumers since privatisation of the electricity
industry in 1990. In no other developed country are pre-payment
meters used by a significant proportion of consumers. After its
privatisation, British Gas adopted a much tougher stance towards
consumers that could not pay their bills, and the number of consumers
cut off increased markedly, bringing the process of privatisation
into disrepute. To avoid this recurring with the electricity industry,
pre-payment meters operated with "smart cards" individual
to each consumer were introduced. Consumers facing difficulty
paying their bills had little choice but to move to a PPM and
the number of consumers paying by such meters increased from about
1 million to more than 3.5 million by 1995 (about 15% of consumers).
The number of consumers using PPMs fell slowly to about 3 million
by 2003, but the increase in electricity prices since then has
led to a substantial increase so that by 2006, the number was
3.8 million and has continued to rise since then.
In 1992, the Regulator capped the extra cost that could be
passed on to PPM consumers requiring that they pay no more than
5% more than standard rate consumers. This cost cap did not concern
the retail supply companies because any costs not recovered from
PPM consumers could be passed on to other franchise consumers.
For the pre-payment meter consumer, there were significant advantages
with this system. It allowed them to continue to receive a supply
of electricity even before they had paid off their debts. They
also did not need to fear receiving a bill of unpredictable size
once a quarter. So PPMs helped with low-income consumers with
budgeting but it imposed extra costs on them and if they really
could not afford their bills, a PPM was no help to them.
PPMs also had an important advantage for retail electricity
supply companies. The meters were set up to use a proportion of
any payments to buy more electricity to pay off existing debts.
The retail companies did not incur the expensive and politically
damaging cost of cutting off consumers that could not pay their
bills. Consumers that could not pay their bill disconnected themselves.
They also meant that debts to them were paid. The extent of the
fuel poverty problem was masked. There is no ready way to accurately
determine the extent of self-disconnection. A survey by the Electricity
Association found that about 24% of PPM consumers self-disconnect
and about 1% (about 36,000 consumers) chronically disconnect (more
than 20 times per year) (Electricity Association 2001, pp 22-23).
Nevertheless, PPMs have proved popular with consumers. They
are generally aware that they are paying a higher price for their
power, but, in the same way as pre-payment mobile phones are popular
despite high call charges, consumers value the extra control over
tight household budgets that the PPM gives them.
Once retail competition had been introduced in 1998, prices
were set by the free market and the companies were no longer required
to maintain the 5% differential and the gap between PPM prices
and those of other payment plans, especially direct debit plans,
has widened. This issue has been continually been highlighted
by consumer groups such as Energywatch and the National Right
to Fuel Campaign, but Ofgem has taken no effective action. However,
in its 2008 Budget, the government announced that it was going
to work with the companies to find new ways to help the poorest
consumers, with the threat that legislation would be introduced
if a satisfactory agreement could not be reached. It remains to
be seen how effective this new initiative will be.
Table 5
PRICES OF ELECTRICITY BY PAYMENT METHOD AND ACCOUNT TYPE
(£/YEAR)
| On-line direct debit
| Direct debit | Standard credit
| Pre-payment |
| SEEBOARD | 306 | 359
| 387 | 390 |
| London | 312 | 372
| 400 | 402 |
| Southern | 327 | 372
| 401 | 405 |
| South West | 336 | 394
| 420 | 422 |
| North West | 321 | 385
| 396 | 404 |
| South Wales | 356 | 409
| 441 | 448 |
| Eastern | 316 | 362
| 387 | 389 |
| Midlands | 338 | 375
| 400 | 406 |
| East Midlands | 322 | 368
| 392 | 398 |
| Manchester/N Wales | 321 |
369 | 396 | 404
|
| Northern | 332 | 382
| 411 | 420 |
| Yorkshire | 326 | 370
| 397 | 408 |
| South Scotland | 336 | 390
| 417 | 426 |
| North Scotland | 342 | 386
| 409 | 418 |
| Average | 328 | 378
| 404 | 410 |
Source: http://www.energywatch.org.uk/help_and_advice/saving_money/index.asp
Notes:
1. Rates were calculated for 21 February 2008 and represent
the average for the six suppliers for a "medium" consumer,
ie, 3300kWh/year.
2. Note, EDF does not offer on-line direct debit terms.
Table 5 shows that, on average a pre-payment meter consumer
now only pays a little more than a standard credit consumer, but
11% more than a direct debit consumer and 25% more than an on-line
direct debit consumer. This seems to represent a worsening from
the position five years ago, before on-line tariffs were widely
offered. Then, Thomas (2004) found that for the London region,
the price for those with pre-payment meters was about 3% more
than standard credit and about 8% more than direct debit. A detailed
analysis of prices on offer in the London region (see Box) shows
that PPM consumers that have not moved from the original monopoly
supplier are now paying 27% more than the cheapest offer, an on-line
direct debit dual-fuel account.
The picture has changed in the past five years. Then, the
most expensive suppliers were almost invariably the incumbents,
presumably because the companies could assume a high proportion
of their existing consumers would never switch and the companies
could exploit this inertia. Now, there appears to be no such relationship
because the proportion of consumers willing to switch might be
high enough to ensure that companies cannot rely on this inertia.
There was also then a significant differential between PPM and
standard credit consumers. This differential no longer exists.
How far this is due to a change in the expected costs of supply
and how far it is down to other factors is impossible to know.
However, five years ago, there was significant criticism of companies
for the high cost of PPMs. Companies can now legitimately, but
disingenuously, claim that their prices for PPM consumers are
now in-line with their standard credit consumers.
The companies claim there are additional costs for supplying
pre-payment meter consumers. While it is plausible that the system
of topping up is more expensive than sending out bills, there
are off-setting cost savings. No meter-reading and billing is
required, payment is in advance, and there is no possibility of
the consumer not paying their bill.
Unless convincing and independently authenticated evidence
is provided to show that these high prices reflect real additional
costs, the companies must be seen as guilty of exploiting the
classes of consumers, pre-payment and standard credit, that contain
the most vulnerable and disadvantaged consumers. If the differential
does reflect real cost differences, there is a need for government
or regulatory action to ensure that vulnerable and disadvantaged
consumers are not in such a poor position for the purchase of
an essential public service.
Ms A's Energy Purchases
Ms A is a single, working mother known to me. She has had
problems with previous debt to energy suppliers, not incurred
by her. Her limited budget and this bad experience mean she values
very highly the assurance pre-payment meters (PPMs) gives that
unaffordable bills will not be incurred even though she is aware
that PPMs are not the cheapest method of paying. She is also reluctant
to experiment with untried energy providers. She lives within
London Electricity's catchment area and buys her electricity from
the previous monopoly supplier, London Electricity (EDF) and her
gas from British Gas (Centrica) using pre-payment meters (PPM).
If we assume she is a "medium user" (3,300kWh/year of
electricity and 20,500kWh of gas per year), the price she currently
pays and her options are shown in the Table. She has five basic
payment options: pre-payment meters; standard credit (SC) terms
(a variable quarterly bill); direct debit (DD) under which a fixed
sum is taken monthly from her bank account; and on-line DD under
which her account is a paperless one operated via the internet.
For all options except PPM, a dual fuel offer is available offering
a small discount over buying the energy under separate accounts.
For clarity, dual-fuel prices are only shown for the cheapest
way of paying, on-line DD.
Care needs to be taken interpreting the Table as Scottish
& Southern Energy (S&SE) is almost invariably the cheapest
supplier for any given class of payment, but the prices shown
here were calculated before it announced a price rise of 14.2%
effective from April 2008. This means that in most cases it is
not now the cheapest supplier.
Table
COST OF PURCHASING ENERGY IN THE LONDON REGION
| PPM |
Standard credit | Direct debit
| On-line DD | On-line DD dual-fuel
|
| EDF/B Gas | |
| | | |
| Electricity | 401 | 401
| 393 | 393* | n/a
|
| Gas | 617 | 656
| 588 | 565 | n/a
|
| Total | 1,018 | 1.057
| 981 | 968 | n/a
|
| Dearest | | |
| | |
| Electricity | 440 (NPower) |
429 (S Power) | 402 (Npower) |
320 (NPower) | |
| Gas | 676 (E.ON) | 656 (B Gas)
| 633 (NPower) | 595 (NPower) |
|
| Total | 1,116 | 1,085
| 1,035 (NPower) | 915 (NPower)
| 876 (S Power) |
| Cheapest | |
| | | |
| Electricity | 353 (S&SE) |
350 (S&SE) | 329(SS&E) |
285 (NPower) | |
| Gas | 579 (S&SE) | 535 (S&SE)
| 503 (SS&E) | 462 (S&SE)
| |
| Total | 932 | 885
| 832 | 747 | 744 (E.ON)
|
| Cheapest (ex SSE) | |
| | | |
| Electricity | 393 (E.ON) |
393 (E.ON) | 357 (S Power) | 285 (NPower)
| |
| Gas | 617 (B Gas) | 642 (E.ON)
| 580 (S Power) | 565 (B Gas) |
|
| Total | 1,010 | 1,035
| 937 | 850 | 744 (E.ON)
|
Source: http://www.energywatch.org.uk/uploads/PriceComparison_london_21February2008.pdf
The Table shows a number of important features:
— On-line Direct Debit dual-fuel, is 27% cheaper
than paying by PPM with the incumbent utilities.
— There is little to be saved within PPM suppliers.
Now that S&SE has increased its prices, the available savings
are negligible.
— Standard Credit terms are now generally little
if any cheaper than PPMs and if Ms A remains with the same supplier
and switches to SC, her bills would actually increase.
— Significant savings are available if Ms A switched
to paying by Direct Debit. The savings would be only about 4%
if she remained with her existing suppliers, but if she switched
to the cheapest, excluding S&SE, she would save 8%.
— However, the big pay-offs arise when on-line DD
are considered. Switching to the cheapest supplier (excluding
S&SE) would save 17%.
— Switching to the cheapest supplier with on-line
DD and a dual fuel offer would increase savings to 27%.
— Now that S&SE has increased its prices from
April, anyone following Ofgem's advice in January and February
to switch is likely to have found that by the time the switch
was complete, S&SE was no longer the cheapest supplier and
their effort was wasted.
3.2 Switching rates and price differentials
Switching rates, that is, the proportion of consumers that
change supplier each year, are frequently used as an indicator
of the health of the retail electricity market, while a clustering
of prices is claimed to be an indicator that markets are not operating
competitively. In both cases, these assertions are misleading.
A market that has little switching because the process is
so onerous or because companies are not actively competing is
clearly not healthy. Equally, if the market is operating efficiently,
competing companies would know they would quickly lose market
share if their prices were significantly higher than their competitors.
In such a market, there would be no need to switch because consumers
would be assured that their supplier would follow closely the
price movements of the market. So a market with a low switching
rate and closely clustered prices could be operating efficiently.
From another perspective, if the market is working well,
prices should cluster. If we look at the components of an electricity
bill, including tax and environmental costs, 35% is accounted
for by elements that are standard for all suppliers, for example,
the transmission charge. Of the rest, about two thirds is the
generation cost. If the wholesale market is working efficiently,
it should be very difficult for one retailer to buy power more
cheaply than another. If we look at most commodity markets, all
buyers pay essentially the same cost for the commodity. This leaves
the supply cost. If one retailer was, say, 20% more efficient
than its competitors, this would allow them to offer power about
6% cheaper than their competitors, hardly a major incentive to
switch for residential consumers. So the existence of major price
differentials is more likely to be an indication of a malfunctioning
wholesale market than an indicator of a healthy retail market.
3.3 Retail costs in a competitive market
It is generally assumed for most products that competition
is a "free good" (or negligible costs) with only benefits
from competition. It is difficult to know what the retailers'
costs are but it is clear they are up to four times as high as
when retail was a monopoly. Some of the additional costs include:
3.3.1 Marketing
Marketing costs range from product advertising in mass media
and sponsorship of sports, to door-to-door and telephone marketing.
These costs are likely to be substantial will inevitably be passed
on to consumers.
3.3.2 Switching costs
The systems to allow retail switching were hugely expensive
to build and are expensive to operate. Offer estimated allowed
the companies to recover £850 million from consumers to pay
for the building of the systems and operation over seven years
from 1998 (Thomas, 2006). The NAO (2003) wrote of "the substantial
costs of processing changes of supplier". In May 2005, the
British energy minister, Brian Wilson, said: "The benefits
of price falls must not be restricted to those who switch, not
least because if everyone starts to switch, the costs of administering
this will outstrip the savings". No reliable estimate of
the average switching cost per consumer exists, but it is unlikely
to be less than about £40. This cost legally cannot be charged
to the switching consumer so is borne by consumers in general.
While not charging consumers to switch will result in higher switching
rates than if they were charged the real cost they were incurring,
it does mean that consumers that do not switch are not only not
receiving the potential benefits of switching, they are having
to pay for the benefits switching consumers receive.
If all consumers switched as regularly as Ofgem advocates
and sufficiently to ensure they were generally on the lowest tariff,
this is likely to require them to switch up to twice a year. Even
if the switching systems were able to cope with this, which seems
unlikely, the annual costs would be in the order £2 billion.
Ofgem's standard response when complaints are made about prices,
that consumers should switch to cheaper suppliers is therefore
ill-thought out and likely to result in extra costs far above
any potential savings from greater competition.
Ofgem should be required to re-estimate the annual cost of
switching so that sensible advice can be given to consumers on
switching.
3.3.3 Higher profits
It is now difficult to see whether energy retailers are making
excessive profits. Four out of six of the energy companies are
subsidiaries of foreign companies and do not publish audited accounts
of their UK businesses. The other two companies, Centrica (which
trades as British Gas in the UK) and Scottish & Southern Energy
offer both gas and electricity, and are also integrated into electricity
generation and, in the case of Centrica, gas production. So it
is difficult to know where their profits come from. In February
2008, Centric reported profits for 2007 of £571 million compared
to £95 million in 2006.
4. IS THE
CORPORATE STRUCTURE
COMPETITIVE?
The corporate structure for the electricity industry, with
six major companies is much more competitive than most countries
in Europe. Nevertheless, using the standard measure of market
concentration (the Hirschmann-Herfindahl Index, HHI), the market
would still be categorised as moderately concentrated (an index
of 1,500). However, the market is still highly regionalised with
the former monopoly supplier for each region still holding perhaps
50% of the residential market, with British Gas holding about
30% of the residential market. This would give an HHI of about
3500, well above the level (1800) that is the threshold for a
highly concentrated market. However, while the fact that, a decade
after the introduction of retail competition, these measures are
still so disturbing does provide ample grounds by itself for the
need for a Competition Commission Inquiry, the issues are more
complex than is suggested by these simple statistics.
4.1 Vertical integration of generation and retail
When the electricity industry was privatised in 1990, there
seemed a clear desire by the government to maintain a corporate
separation between generation and retail. The reason for this
was clear. The rationale for the new structure was to force generating
companies to compete with each other "every half-hour of
every day". At that time, generation accounted for over half
the cost of electricity. Most of the rest of the cost was made
up by activities that would remain monopolies, so it did not seem
likely the new structure would lead to major cost reductions in
these activities. The benefit to consumers would come from the
operation of an efficient electricity wholesale market, which
would force generators to continuously force their costs down
to the minimum they could achieve. The prices in this market would
also act as investment signals, stimulating new investment when
the price was high and ensuring that investment in new capacity
kept pace with demand.
If generation and retail had been allowed to integrate, the
majority of power would have been produced by generators and sold
directly to their retail customers, bypassing the wholesale market.
With low liquidity, the wholesale market would not have been an
arena where independent generators and retailers could risk trading
a significant proportion of their power and would not provide
reliable investment signals.[401]
The logic of the need to separate generation and retail was
so compelling that in many countries that copied the British structure,
it was illegal for the same company to generate power and sell
to final consumers. However, while the British government did
try to maintain a separation between the generators and the 14
privatised retail companies, it caved in to pressure from the
generators in 1998 and very quickly, the 14 separate and competing
retail companies were taken over by five large generation companies.
Annex 2 gives greater details on the history of this change.
The most recent development concerns the one remaining major
independent generator that does not have a retail business, British
Energy, the privatised nuclear company. British Energy did buy
a retail company (SWALEC) in 1999, but sold it a year later. This
may have contributed to its collapse in 2002. Eventually it was
rescued by government at huge cost to taxpayers in a deal that
effectively gave the government 65% of the shares. In June 2007,
the government sold 30% of the shares and in March 2008, it announced
it was looking to sell the remaining 35% of the shares and would
not exercise its Golden Share which allowed it to veto any company
owning more than 15% of the shares. Separately British Energy
announced that it was in talks with a number of companies about
a full takeover. The likelihood seems to be that British Energy
will be partly or fully taken over by one of the six integrated
generator retailers.
Investment in new generation in Great Britain continued after
privatisation because of the failure of the wholesale market to
bring down prices (the so-called "Dash for Gas" in 1991-92
and a second "Dash for Gas" in 1997-98. New generators
could produce power at well below the market price and it seemed
that investing in new plant represented a low risk. After the
wholesale price fell in Britain in 2002, new investment would
have become much riskier if the generation and retail had been
separate because there would have been little assurance that a
new entrant could produce at lower than the market price. However,
the market is now dominated by a handful of integrated companies
so investment risk is low because the companies are selling direct
to consumers that cannot easily switch rather than into a half-hourly
market. The risk that there will be insufficient generating capacity
may also be lower. Integrated companies will tend to ensure they
have enough capacity to supply their own consumers reliably. So
supply security may be improved by integration, but the price
will be much reduced competition.
However, the intuitive conclusion that if integration of
generation and retail is destroying competition, this form of
integration should be prevented is dangerous. As stand-alone businesses,
both generation and retail supply are highly risky businesses.
Investment in new power plant will be seen as highly risky if
the plant owner has to sell the output into a competitive market
in which the prices and volumes sold will not be predictable from
one hour to the next. For a standard product like electricity,
retail suppliers will quickly lose their market share if they
cannot match the cheapest prices on offer. The evidence from California
and Brazil, where integration was not allowed and investment in
new generation collapsed after liberalization, is not encouraging.
4.2 Emergence of five dominant European players
These changes in the UK must be seen in the context of changes
in the corporate structure of the electricity industry in Europe.
Like the UK, the European Union has been pursuing a policy of
liberalisation of electricity markets but, ironically, the result
of the attempt to introduce competition has been a massive process
of corporate concentration and the emergence of an oligopoly of
about five major players present in several countries. Thomas
(2003) wrote about the Seven Brothers in 2003, examining the proposition
that seven or eight companies would dominate European electricity
markets.
Of the eight companies considered by Thomas as candidates,
three were then already significantly larger than the other companies.
These three companies, EDF, E.ON and RWE, were the first European
companies to enter the UK and remain very powerful throughout
the rest of Europe as well as in their home markets and the UK.
Of the other five possible companies identified by Thomas: ENEL
(Italy) is in the process of taking over another of the companies,
Endesa (Spain); and Electrabel (Belgium/France) is in the process
of merging with the gas equivalent of EDF, GDF. However, Vattenfall
(Sweden) appears not to have the scope for further expansion and
Iberdrola (Spain) has taken over Scottish Power, but is now under
threat of takeover by EDF. The five dominant companies likely
to emerge from this process, EDF, E.ON, RWE, ENEL and Electrabel/GDF
are comparable in size and would have the resources to take over
either of the two remaining British integrated companies, Centrica
and Scottish & Southern Energy as well as the nuclear generator,
British Energy.
4.3 Prospects for new entry
The Energy Minister, Malcolm Wicks expressed concern in February
2008 about the lack of new entry to the retail market since 2003
saying he wanted to raise the issue with Ofgem.[402]
However, the prospects for potential new entrants are now very
poor and the reason for this is the actions of Ofgem and the government
itself in allowing integration of generation and retail. New generators
will only be able to enter the market if they can obtain a long-term
contract to sell their power to one of the integrated companies.
Such deals will contribute little to competition in generation.
A new retailer will find it difficult to obtain wholesale supplies
because generation is dominated by integrated companies. If, as
now seems likely, British Energy, the only large independent generator
left, is taken over by one of the six integrated companies, the
proportion of capacity not owned by these six companies will be
even smaller.
US companies moved rapidly into the UK market as soon as
the "Golden Share" provisions that allowed government
to veto takeovers of the privatised companies expired in 1995.
However, many exited within a year or two, while the UK subsidiaries
of those that remained after 2000, almost all went bankrupt. Experience
by these US companies in other markets was generally little if
any better, and virtually all the US companies have now withdrawn
from all non-US markets after suffering heavy losses. The prospects
that any US utilities will try to enter the UK market again in
the next decade or so seem slim. Investment organisations, such
as Macquarie Bank and Ontario Teachers' Pension Fund and SE Asian
companies have invested in UK utilities, but they seem only interested
in regulated network activities, where the commercial risk is
much lower than for electricity generation and retail.
A particular issue for prospective small new entrants is
the so-called balancing market for power. This is a complex mechanism.
Essentially retail companies have to forecast the demands of their
consumers a day ahead and generators have to declare which power
stations will be used so that the system operator (National Grid
Transco) can check the compatibility of these plans with the transmission
network and with their own (more accurate) forecast of demand.
Inevitably, the retailers' forecasts will not be precisely accurate
and the system operator will, an hour ahead, have to buy additional
generation or pay for a generator not to generate so that supply
and demand do balance precisely. The price in the balancing market
to generate extra power at short notice has proved to be highly
variable and is often very high. For a large integrated company,
this risk is manageable. For a small new entrant retailer, if
their forecast is, say, 10% too low at a time when the balancing
price to buy extra power is, say 10-50 times the normal market
price, the company could easily be bankrupted.
So new entry to the UK only seems likely from European companies
with only the five emerging, dominant players having the size
to move into the UK market or expand their existing position here.
EDF, RWE and E.ON will probably remain strong forces in the UK
market. The other three UK integrated companies (Centrica, S&SE
and Scottish Power) and British Energy must be seen as takeover
targets for these three companies or the other two major European
companies, ENEL and Electrabel/GDF that have yet to establish
a position in the UK. The latter company has already bought a
major UK power station in 2008 signalling its intention to move
into the UK market.
5. IS THE
REPORTED WHOLESALE
PRICE A
RELIABLE PRICE
INDICATOR?
5.1 The Pool and NETA/BETTA
As discussed earlier, from 1990-2002, the wholesale market
for England and Wales was the Power Pool, which was a market all
generators and retailers had nominally to operate through. In
practice, the allowing of hedging contracts meant that the prices
bid into the Pool had little or no impact on price-setting in
the wholesale market. However, the terms and prices of the contracts
were mostly known to the regulator at least up to 1998 because
residential consumers were still captive to their regional company
and the regulator had to be assured that the companies were only
passing on to their captive consumers the costs they were actually
incurring.
The Pool was replaced by a new spot market, the New Electricity
Trading Arrangements (NETA), which in 2005 became the British
Electricity Trading and Transmission Arrangements (BETTA), when
Scotland was integrated into the England & Wales market. NETA/BETTA
is a voluntary market and generators and retailers are free to
sign confidential contracts outside the visible spot market. Whilst
NETA/BETTA is immensely complex in detail, for these purposes,
as we will argue, the fact that power can be bought and sold on
confidential contracts outside NETA/BETTA is the key point.
The justification provided by energy retailers for the price
increases of 2004-06 and for 2008 was that they were forced to
pass on wholesale price increases to consumers. This begs the
question: is the published wholesale price from BETTA a reliable
indicator of the price retail companies pay for their power? Statistical
analysis of day-ahead wholesale prices and retail prices found
no correlation between these suggesting that there is no statistical
basis for this claim (Waterson et al, 2008). But on a number
of practical grounds, it is clear that the wholesale price is
not a reliable indicator.
5.2 The day ahead market is not liquid
The only market for which prices are published is the "day-ahead"
market for each 30-minute period. This is essentially a market
used by the companies for fine-tuning their purchases, buying
additional or selling surplus power. The volumes traded are minimal
and the prices fluctuate dramatically from one period to the next.
For example, in December 2007, the highest half-hour price on
this spot market was £400/MWh, while the lowest was £15/MWh.
The total turnover for the month was 857GWh. Total demand for
the month was of the order 40,000GWh. So it can be seen that only
a very small proportion of wholesale sales pass through the day-ahead
market.
5.3 All retailers can cover a large proportion of their
sales from own capacity
All six major companies are able to cover 50% or more of
their power needs from their own coal- and gas-fired plant. The
transfer price from the generation to the retail division of this
power is not known and, if the fuel used to generate this power
is bought on long-term contracts, the price of this fuel may not
be strongly related to spot market gas and coal prices.
5.4 The rest of the purchases are on medium- or long-term
contracts
There remain three significant independent power producers
that do not have retail businesses, International Power (2.8GW),
Drax Power (4GW) and British Energy (10.8GW). These companies
own about a quarter of British generating capacity and supply
a somewhat higher proportion of British power needs (their plants
are used more intensively than average). All three companies are
potential takeover targets for the six integrated companies. These
independent generators were selling their power through short-term
and spot sales in 2002 and British Energy and Drax Power (then
owned by a US company, AES) both collapsed financially when the
short-term price fell sharply. They now sell their power primarily
via medium- and long-term contracts to the six major retail companies.
The terms of these contracts are known only to the two parties
involved and are highly unlikely to have a systematic relationship
to electricity spot market prices.
6. CONCLUSIONS
Detailed analysis of prices shows that even in the period
1990-2002, when prices for electricity were falling in real terms,
the wholesale electricity market was not working well. Large cost
reductions experienced by the generating companies were not passed
on to consumers as would have been expected to occur if the wholesale
electricity market had been an efficient one. Experience since
2002 has demonstrated that the retail electricity market is also
not efficient and has allowed the electricity companies to increase
prices to residential consumers without convincing justification
and not pass on cost reductions. So the current problem is not
an isolated one in an otherwise successful system.
The assertion by the six electricity retail companies that
large price rises for electricity imposed in the first quarter
of 2008 are justified by movements to the wholesale market price
for electricity is not supported by the evidence they have given.
The liquidity of the visible wholesale market is negligible and
the six companies buy nearly all their own power from their own
power stations or from independent power producers under long-term
contracts. The connection between the cost of these purchases
from their own sources and under long-term contracts, and the
published price in the spot market is weak. There are strong suspicions
that this is not the first time the companies have manipulated
prices to their advantage. In 2002, the wholesale electricity
price fell by 40% but none of this was passed on to residential
consumers. In 2005-06, the companies increased their prices by
50% or more citing high wholesale prices, but when wholesale prices
fell in 2006, the price reductions were minimal.
Residential consumers already face a near impossible task
in trying to get the best deal for their power purchases. They
have to choose a supplier knowing only the current relative prices,
which in a volatile market could easily have changed even before
the switch to a new supplier has been completed. They have to
compete with large users to buy power and the retailers have a
history of systematically allocating their cheapest power purchases
to large users, presumably because of their stronger negotiating
power. The companies also discriminate against poorer consumers,
offering much lower prices to those that can afford to pay by
direct debit and who have access to, and are confident with the
internet. Pre-payment meter and standard credit (quarterly variable
bills) consumers might pay a third more than direct debit consumers.
The companies have provided no convincing evidence that this price
differential is justified by real cost differences.
The structure of the electricity industry has become significantly
less competitive and more concentrated in the past decade, with
the implicit approval and sometimes at the instigation of both
the government and the regulatory authority, Ofgem. Further changes
are likely that will make the situation worse. In the case of
the likely takeover of British Energy, which will remove the main
independent power producer, the change was at least in part prompted
by the government itself. This reduction in competition will give
consumers even less confidence that prices are being set competitively
by the market. It will leave residential consumers even more vulnerable
to the market power of the oligopoly of a handful of European
companies that increasingly dominate UK as well as European energy
markets.
Solutions to these problems are not easy. When confronted
with such serious market failures, it is tempting to recommend
pro-competition measures, such as breaking up the companies, forcing
greater use of visible spot markets and reducing the extent of
integration of generation and supply. However, the result of such
measures could be to jeopardise security of supply if, as seems
likely, independent generation companies would profit more from
power shortages than from investing in new capacity.
The regulator, Ofgem, has a poor record. Dubious price movements
in 2002, 2004-05, 2006 passed with no serious investigation by
them and their response to the latest price rises was belated.
There must be suspicions that it was only prompted by public outrage
and the announcement of the BERR Select Committee investigation.
Ofgem's announcement of its inquiry gives concern that Ofgem will
be looking to shift blame elsewhere. It states: "We are concerned
about the increased volatility of wholesale prices and we want
to investigate how European and other global energy market developments
are affecting energy bills in Britain". Fundamental issues
such as the efficiency of the British wholesale market and the
corporate structure in Britain are nowhere mentioned. Ofgem has
also consistently failed to tackle the issue, long recognised,
of price discrimination amongst residential consumers which results
in pre-payment and standard credit consumers paying far more than
direct debit consumers.
A more impartial investigation than can be carried out by
Ofgem is needed and the Competition Commission seems the most
appropriate body to carry out such an investigation. The issues
it would need to examine are:
— Do movements in the price actually paid for power
by retailers justify the January 2008 price increases?
— What if any is the relationship between the published
spot price for electricity and the price paid by retailers for
power?
— Do cost differences justify the price differences
between the tariffs offered to pre-payment meter and standard
credit consumers, and to consumers paying by direct debit?
— Are residential consumers paying disproportionately
more for their power than large industrial consumers?
— What are the costs of switching by residential
consumers and, if as seems likely they are high, can these costs
be reduced to more affordable levels?
— Is the structure of the electricity market competitive
and, in particular, would the takeover of British Energy by one
of the existing retailers lead to serious competition issues?
If the problems identified cannot be remedied by changes
to the market, a return to a more strictly regulated system of
tariffs may be necessary.
The problem of the ineffectiveness of Ofgem is a serious
one and needs to be addressed separately. There must be doubts,
given its role in designing the wholesale market and presiding
over the corporate changes in the industry, whether it is now
too compromised to carry out its primary duty of protecting the
interests of consumers. A more comprehensive reform of regulation
may be required.
REFERENCES
Cornwall Energy Associates, 2008, "Gas and electricity costs
to consumers", Paper for the National Right to Fuel Campaign
and Unison prepared by Cornwall Energy.
Electricity Association, 2001, "Affording Gas and Electricity:
Self Disconnection and Rationing by Prepayment and Low Income
Credit Consumers and Company Attitudes to Social Action",
Electricity Association, London.
I Lang, 2002, "Blue Remembered Years", Politico's, London.
National Audit Office, 2003, "The New Electricity Trading
Arrangements in England and Wales" Report by the Comptroller
and Auditor General HC 624 Session 2002-03: 9 May 2003.
Power UK, 2002, "Prices fall for some but stay the same for
others", No 97 (March 2002), 27-8.
S Thomas, 2003, "The seven brothers" Energy Policy,
vol 31, 5, pp 393-403.
S Thomas, 2004, "Evaluating the British Model of electricity
deregulation" Annals of Public and Cooperative Economics,
vol 75, 3, pp 367-398.
S Thomas, 2006, "The British Model in Britain: failing slowly"
Energy Policy, vol 34, 5, pp 583-600.
M Waterson, M Giulietti & L Grossi, 2008, "The missing
link" Power UK, issue 167, January 2008, pp 60-66.
C Waddams-Price (2004) "Spoilt for Choice? The Costs and
Benefits of Opening UK Residential Energy Markets". CCR Working
Paper 04-1. Also published as University of California Energy
Institute Working Paper CSEM WP-123.
Annex 1
A DETAILED BREAKDOWN OF SUPPLY COSTS
Cornwall Energy (2008), in a paper commissioned by UNISON
and the National Right to Fuel Campaign has tried to establish
a more detailed breakdown of the current cost of power for residential
electricity consumers (Table 7). If we include system losses with
generation, the generation element makes up 35% of the total cost
(excluding taxes and subsidies); distribution (including metering)
comprises 21%; transmission 3%; leaving 41% to cover the supply
cost and profits.
There appears to have been a four-fold increase in profits
from 2003-06 and, if Centrica's profits for 2007 are a guide,
the percentage of the price made up by profits will have increased
again sharply in 2007. Marketing costs are likely to have fallen
given that most of the companies are no longer employing major
door-to-door and telephone marketing efforts.
While distribution and transmission have fallen as a percentage
of the bill, they are increasing, reflecting extra costs associated
with integrating renewables, but also, as argued in section 2.4,
the fact that the industry was sold at a small fraction of the
asset value and the pre-privatisation assets are now having to
be replaced.
Table 6
COSTS OF SERVING RESIDENTIAL CONSUMERS—£m (%)
| 2003 |
2006 | % change 2003-06
|
| Fuel costs | 1,815 (25) |
3,020 (27) | 66 |
| System losses | 499 (7) |
878 (8) | 75 |
| Distribution charge | 1,610 (23)
| 1,734 (16) | 8 |
| Metering | 526 (7) | 543 (5)
| 3 |
| Transmission charge | 190 (3)
| 298 (3) | 57 |
| Suppliers' cost to serve | 903 (13)
| 908 (8) | 1 |
| Profits | 557 (8) | 2,635 (24)
| 373 |
| Residual | 1,020 (14) | 983 (9)
| -4 |
| Total (exc tax and environmental) | 7,120 (100)
| 10,999 (100) | 54 |
| Energy efficiency commitment | 97
| 182 | |
| Renewables obligation | 148
| 256 | |
| Total | 7,365 |
| |
Source: Cornwall Energy Associates
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Annex 2
INTEGRATION OF GENERATION AND RETAIL
The British government has been inconsistent about integration
of generation and retailing electricity. Because of strong opposition
in Scotland, from across the political spectrum (Lang 2002), to
the break-up of the two nationally-owned Scottish electricity
companies, these were privatised intact as two fully vertically
integrated companies. However, the Scottish electricity industry
has now being absorbed into that of England and Wales.
In England and Wales, the 12 regional retail supply companies
were allowed to build their own power plants and the generators
were allowed to supply directly the large consumers who were able
to choose their electricity supplier. The situation became more
confused in 1995 when Scottish Power was allowed to take over
a regional company in England and Wales (Manchester and North
Wales Electricity Board). At that time, Scotland was commercially
separate from England and Wales but physically interconnected.
Improvements to the interconnections were underway and it was
clear that Scottish Power would be able to operate as an integrated
company in England and Wales. A regional company, Eastern, had
bought the plant the Regulator had forced the two large privatised
generators, National Power and Powergen, to sell in 1995, also
creating a large integrated company. However, the proposed take-over
in 1996 of regional companies by both National Power and Powergen
caused government to think again.
These two companies still had immense power in the generation
market and allowing them to take over regional companies would
have been a risk to competition and the take-overs were prevented.
Only two years later, renewed take-over bids by the duopoly were
allowed. It is not clear why the government changed its position
on vertical integration. What had changed was that the market
share of National Power and Powergen in generation had fallen
and the government required, as a condition, that the duopoly
sell more of its plant to new entrants. National Power and Powergen
were also experiencing financial difficulties because long-term
gas contracts they had signed had proved to be over-priced. Between
them, the two companies had to write off about £1.5 billion
in 1998-99 on these contracts. The government may have been concerned
that these problems had so weakened the companies they would have
been vulnerable to foreign take-over. Allowing them to integrate
appeared likely to give them more strength. In fact, this protection
was ineffective. In 1999, National Power had to split itself into
a UK business and an international business. The UK business of
National Power was taken over by RWE in 2002 while Powergen succumbed
to E.ON in 2001.
The decision on vertical integration of National Power and
Powergen opened the floodgates to integration and by 2002, the
14 retail businesses of Great Britain (12 in England and Wales
and two in Scotland) had all been taken over by generators. Now
five integrated companies dominate generation and retail supply.
RWE, E.ON, EDF and Scottish & Southern Energy each own three
regional companies, and Scottish Power owns two. A sixth company,
Centrica (trading as British Gas), has made significant inroads
into the retail market for residential consumers and owns a significant
amount of plant. There is every prospect that, in the next year
or two, further mergers and take-overs will leave just three or
four dominant companies.
The risks of this form of vertical integration to consumers
were soon apparent. 40% of Britain's generating capacity was in
serious financial difficulties at the start of 2004. Some was
for sale at distress prices, some had been repossessed by the
banks that lent money to the owners and the nuclear plants were
owned by companies that were only able to continue to trade because
of government support. This 40% of capacity was owned by non-integrated
generators. The integrated companies get most of their power from
their own plant or under long-term fixed price contracts and are
little exposed to the markets. When the wholesale electricity
price as measured by the wholesale market price fell, the integrated
companies did not pass on the reduction to consumers (National
Audit Office 2003). The non-integrated companies, most of whom
had only bought their plants in 2000-01, were much more seriously
exposed to the price reduction and began to lose money heavily.
While this form of integration significantly reduces the
risks to electricity generators and retailers, it is not a guarantee
against failure. In Great Britain, by about 2000, TXU, a Texas-based
electric utility held about 4000MW of generation and supplied
to two regions and was widely seen as having a very strong position
in the British market. However, it contracted too much power at
a high price from an independent power producer, sustained heavy
losses and was bought out by E.ON in 2002.
March 2008
397
A very small proportion of this subsidy was paid to renewables. Back
398
Commission decision of 22 September 2004 on the State aid which
the United Kingdom is planning to implement for British Energy
plc. Official Journal of the European Union. L/142 26-80. http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2005:142:0026:0080:EN:PDF Back
399
It should be noted that these figures should not be taken as an
indication of which is the cheapest supplier. The companies that
show relatively small increases might have been expensive suppliers
at the start of 2004. Back
400
National Audit Office (2003) "The New Electricity Trading
Arrangements in England and Wales" Report by the Comptroller
and Auditor General HC 624 Session 2002-03: 9 May 2003. Back
401
The first design of wholesale market, the Power Pool required
generators to bid all the plant they wanted to operate into the
Pool with only successful bidders allowed to generate. However,
hedging contracts were allowed that meant that the price generators
bid into the Pool bore no resemblance to the price they were actually
paid and bids were little more than a charade. Back
402
Power UK, "Wicks to raise entry issues with Ofgem" Issue
167, January 2008, pp 57-58. Back
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