Memorandum submitted by Professor Michael
Waterson, Professor of Economics, University of Warwick
INVESTIGATION INTO POSSIBLE ANTI-COMPETITIVE
BEHAVIOUR IN THE UK's ENERGY MARKET
1. EXECUTIVE
SUMMARY
Together with other academics, I have investigated
the linkages between domestic electricity retail prices, wholesale
prices and prices of the underlying fuels over the period since
2001, following reforms both in the retail supply market and in
wholesale market trading arrangements. We find that despite these
reforms, there is significant price dispersion between suppliers
in their offers to domestic consumers. Surprisingly, we also find
rather little observed linkage between retail and wholesale prices
for electrical power. To this extent, the operation of what is
intended to be a competitive market is somewhat opaque.
2. BRIEF INTRODUCTION
I am Professor of Economics at the University
of Warwick, a post I have held since 1991. My specialist research
area is Industrial Economics and I have recently been working
on topics in the area of domestic energy supply, in partnership
with various other scholars. This area interests me academically
because the UK is in the vanguard of moves towards competition
in generation and in supply. I have a paper in the Economic
Journal (2005) with two other scholars on consumer switching
in the gas industry (funded by the Leverhulme Trust) and am currently
working on pricing behaviour in domestic electricity supply, focusing
on firms' strategies. This latter work is funded by the ESRC and
is joint with Monica Giulietti, an academic at Aston Business
School (and has been assisted by a visiting statistician, Luigi
Grossi). The conclusions I summarise above, and the more detailed
comments below, relate in large part to our current (and somewhat
preliminary) work on investigating trends in domestic supply prices
and on linking domestic electricity supply prices and wholesale
energy prices. We have not been working on retail gas prices at
this particular stage. I should also make clear that we are interested
in the topic as independent academics engaged in a study of markets
and, in particular, we are not engaged by OFGEM, or any of the
energy supply companies, nor any similar parties.
3. POINTS ON
WHICH I FEEL
I CAN COMMENT
Below I make comments in several areas relating
to the bullet points in the announcement of inquiry, where these
link with our investigation. I do this in the order of the points
that you make, but I can comment more fully on some than others.
Where I write retail below, I refer only to domestic retail.
4. You ask whether the current market structure
encourages effective competition in the retail markets for gas
and electricity. Certainly it has been designed to do that. In
my opinion, it does so imperfectly. However, whether an alternative
system would do better is I think a moot point. To elaborate somewhat,
the current structure certainly leads to a very large amount of
switching between suppliers; approximately 20% of consumers switch
supplier in any year. A good deal of this switching appears to
be what might be described as "churn" and a substantial
minority of consumers appears uninterested in switching supplier.
Our analysis of pricing trends in the market has suggested that
substantial percentage price differences between suppliers can
coexist in the market, despite the seeming homogeneity of the
product. In particular, an incumbent supplier (the firm that would
be your supplier had you never switched) has historically been
able to command around a 10% price premium over the average of
other suppliers. However, there is some evidence that this premium
is declining. Within the set of other suppliers, significant price
differences appear, up to 30% at times, although these commonly
do not persist for long periods (that is, there are commonly these
differences, but any one company is not consistently a "best
buy" for long). Why do I say that it is a moot point whether
an alternative system would be better? Other academic studies
on pricing dispersion more generally (with different products)
show that pricing differences across suppliers are very common,
and that the percentage magnitude of these differences is not
out of line with the results above. Nevertheless, it is perhaps
unusual considering the importance of electricity in many peoples'
budgets.
5. I would say that the workings of the
wholesale market are somewhat opaque. I have obtained from Platts,
one of the three main data supply companies in this area, price
data for wholesale electricity and gas. However, these data refer
only to rather short-dated supply, up to one month out. Platts
tell me data for less prompt contracts are not readily available.
However, I have also been told by an industry representative that
the majority of contracts they engage in are for much longer dates
than those for which I have price data. Since these are bilateral
contracts, whose terms are only known by the two parties themselves,
it is difficult to get a view of how the market as a whole is
operating. As with any commodity, it is normal in order to reduce
the risk inherent in an energy portfolio for the energy company
to hold a set of contracts diversified as to maturity. What is
somewhat surprising is that the short term signals do not necessarily
reflect what the supply companies tell us are underlying movements
in the longer term market. In addition, so far as I am aware,
there are no third parties providing liquidity.
6. One intriguing aspect of the current
market is the consolidation amongst suppliers. So far as domestic
electricity supply is concerned, independent operators seem to
have been squeezed out of the market. Since these operators tended
to have the most financially attractive tariffs, price pressure
on the bigger companies may have been lessened. As to why the
independents have been squeezed out, I conjecture that one consequence
of the replacement of the Pool system by NETA was that it became
more difficult for independents to obtain adequate cover against
market price risk. In contrast to independents, the major suppliers
are all significantly vertically integrated and therefore have
significant cover against price risk on the supply side. Having
said this, I do not feel there is any intrinsic reason why a market
with six suppliers and active consumers should be markedly uncompetitive.
7. My remarks on the relationship between
wholesale and retail markets for electricity should be prefaced
by a point made above. We have price series for wholesale electricity,
but only on a day-ahead and month-ahead basis. We also have price
series for retail prices (over a standard set of contracts), collected
from the energywatch website. We have examined the relationship
between these series of wholesale and retail prices for the time
period 2001- February 2007. Expressed in terms of returns (as
one would in comparing say the movements of one particular share
against a market portfolio), there is essentially no statistically
significant relationship between the two series. "In sum,
these simple cross-correlation experiments suggest no strong link
between the relatively shortdated wholesale prices for which market
data are available, and retail prices. This is not because retail
prices are simply a smoothed version of wholesale prices. Rather,
the series show quite different characteristics". (a quote
from the article in Power UK I wrote, attached to this memorandum).
I find this a most surprising result. In my opinion, it does put
the onus on the supply companies to explain where they view the
underlying cost pressures as arising. We may also note here that
the other elements of cost are unlikely to be of the magnitude,
nor the variability, to provide the missing explanation.
8. I am not able to comment in any detail
on the interaction between UK and European energy markets.
9. The main regulator, OFGEM, has in my
opinion focused on developing the prerequisites for competitive
operation of the generation and supply markets, rather than on
micromanagement of these markets. It therefore focuses on market-driven
solutions to perceived problems in supply. It has also eagerly
embraced the NETA and BETTA arrangements it devised for trading
electricity. In part because other European nations have more
of a "command and control" approach to energy supply,
the UK may be more exposed to price movements in the market.
10. I am not able to comment on the issue
of fuel poverty, save to note that the proportion of consumers
of electricity who are on Prepayment terms is quite high.
March 2008
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