Regulation of the Electricity Industry Research Paper 94/93
1 August 1994
This paper examines the regulation of the UK electric industry. It discusses the role of the Director General of Electricity Supply, and the effects of this on prices and competition within the industry.
Christopher Barclay Science and Environment Section
House of Commons Library REGULATION OF THE ELECTRICITY INDUSTRY
I. Introduction
The idea of a privatised industry regulated by an independent regulator dates back to the privatisation of the telecommunications industry in 1984. The basic principle has remained largely the same, with a licence being issued by the Secretary of State and the regulator ensuring that the licence conditions are complied with in subsequent years. However, the regulators have far more importance than that simple description would imply. None has a more complex job than the Director General of Electricity Supply, Professor Stephen Littlechild.
Some of the complexities relate to the competitive structure in the industry while others stem from the fact that the electricity industry uses coal, nuclear power and gas as fuels, so that decisions about electricity have enormous consequences for other energy industries. It has become increasingly clear that major decisions have to be taken, going far beyond a simple refereeing role to ensure compliance with the terms of the licence. This role has become controversial, with some critics calling for a different system of regulation, either in the form of a Regulatory Commission or with a revised system incorporating greater democratic accountability.
This paper sets out the statutory basis for the Director General of Electricity Supply (DGES) and describes how his powers have been used. It discusses some consequences for the UK energy industry as a whole and considers some other regulatory models which have been suggested.
II. The Statutory Basis
The statutory basis for regulation of the electricity industry is the Electricity Act 1989 which provided for the privatisation of the electricity industry. As with all British regulation of privatised industries, the statutory duties and powers are laid upon the regulator in person and not upon the office. The Act provides for the Office of Electricity Regulation (OFFER) this office is set up to assist the Director General in the carrying out of his duties. There can be no question of OFFER employees voting on an issue or overriding the Director General. One (perhaps undesirable) consequence of this position is that the business of regulation can become rather personalised and it is difficult to comment on regulatory policy in an industry without making judgements about personal actions.
The Act assigns certain functions to the DGES and lays down some general duties for him. The first main function concerns the granting of licences for the generation, transmission or supply of electricity. The licences are granted by the Secretary of State, after consultation with the DGES (section 6) or the DGES acting with the consent of the Secretary of State. The second main function concerns the modification of licences. Modification can take place with the consent of the holder of the licence (section 11). Alternatively (section 12), the DGES can use an important power to refer the option of licence modification to the Monopolies and Mergers Commission. The Commission then investigates whether the issue specified in the reference operates, or may be expected to operate against the public interest. If so, it will report whether the problem could be remedied or prevented by modifications of the conditions of the licence. The third main function is that of enforcement, and the DGES has powers (section 25) to make an order to secure compliance with a licence condition should the licence holder be contravening it or be likely to contravene it.
Although it does not come across explicitly in the legislation, one of the main functions of the regulator is to decide upon the formula for price control, which is reviewed at five-yearly intervals.
To provide the framework for carrying out these functions, the DGES is given duties which are shared with the Secretary of State (s.3).
(1) The Secretary of State and the Director shall each have a duty to exercise the functions assigned or transferred to him by this part in the manner which he considers is best calculated - (a) to secure that all reasonable demands for electricity are satisfied; (b) to secure that licence holders are able to finance the carrying on of the activities which they are authorised by their licences to carry on; and (c) subject to subsection (2) below, to promote competition in the generation and supply of electricity.
Provision is made for avoiding price discrimination in Scotland, and (sub-section 3) the functions are to be carried out in the manner best calculated -
(a) to protect the interests of consumers of electricity supplied by persons authorised by licences to supply electricity in respect of - (i) the prices charged and the other terms of supply; (ii) the continuity of supply; and (iii)the quality of the electricity services provided; (b) to promote efficiency and economy on the part of persons authorised by licences to supply or transmit electricity and the efficient use of electricity supplied to consumers; (c) to promote research into, and the development and use of, new techniques by or on behalf of persons authorised by a licence to generate, transmit or supply electricity; (d) to protect the public from dangers arising from the generation, transmission or supply of electricity; and (e) to secure the establishment and maintenance of machinery for promoting the health and safety of persons employed in the generation, transmission or supply of electricity; and a duty to take into account, in exercising these functions, the effect on the physical environment of activities connected with the generation, transmission or supply of electricity.
In carrying out these activities, the DGES and Secretary of State have to take into account the protection of the interests of consumers of electricity in rural areas and the interests of those who are disabled or of pensionable age.
III. The Competitive Structure of the Industry
The problem of ensuring competition in an industry which was previously a state-owned monopoly is an extremely difficult and important one. On the one hand, if no competition is produced, it is hard to see much benefit from privatisation except for the original shareholders of the company. On the other hand, the breaking up of a large corporation to produce competition may easily result in costs due to loss of economies of scale. The result might actually be higher prices for the consumer.
In the case of electricity, a serious attempt was made to introduce a considerable amount of competition, particularly in generation. Nuclear power proved a complicating factor. The original plan was to make National Power large enough to carry the nuclear power stations, with about 70% of generating capacity in England & Wales, leaving PowerGen with the remaining 30%. That plan failed when it was decided that nuclear power could not be sold off. Nuclear Electric was then retained in state ownership, with around 20% of capacity. National Power and PowerGen were left as the two private sector generators, but with National Power having more of the capacity, around 50% to PowerGen's 30%. In Scotland, it had been intended to privatise the South of Scotland Electricity Board, which had relied heavily upon nuclear power, but the decision on retaining nuclear power in the public sector resulted in the creation of Scottish Nuclear and ScottishPower. In addition the North of Scotland Hydroelectric Board was privatised as Hydro-Electric.
The regional electricity boards in England and Wales were converted into regional electricity companies (RECs) which buy electricity from the generators and distribute it to customers, though some have since become involved in generation. The national grid was separated and is owned by a separate company, the National Grid Company (GridCo) whose shares are currently owned by the RECs, but which might be floated independently.
In a sense, privatisation was about the right of electricity generators to choose their fuel and about the right of the electricity distribution companies to choose their generators, although both concepts are far more complex than they sound.
The existing generators are obviously constrained by the nature of their existing power stations, many of which are coal-fired. Around 90% of National Power's electricity is produced from coal, and their moves towards diverse fuel supplies have been restricted by the imposition of five-year contracts with British Coal. The second, and last, of these runs until 1998. The company will partly diversify by increasing coal imports (to which end it has been increasing importing capacity) and partly by building Combined Cycle Gas Turbines (CCGTs). The position is similar with PowerGen, which has about 80% of its total fuel burn from British deep-mined coal. Again, the plan is to reduce reliance on coal by building CCGTs.
The position of nuclear power has been strengthened by the Fossil Fuel Levy of around 10% on electricity generated by the burning of fossil fuels, and the accompanying Non-Fossil Fuel Obligation (NFFO) requiring electricity distributors to take some of their power from sources that do not involve the burning of fossil fuels. Around 2% of levy revenue also operates to benefit alternative sources of energy such as wind power. The levy will expire in 1998, although some arrangements to continue supporting alternative sources of power will probably be acceptable to the European Commission. Nuclear Power is not expected to benefit from any such levy after 1998. In the meantime, nuclear electricity has been gaining an increasing share of the market.
An important trend is the loss of market share of National Power and PowerGen in supplying the market in England & Wales. At vesting day, they held around 78% of the market while the remaining 22% was supplied by Nuclear Electric or by companies in Scotland or France supplying electricity through the interconnector. This latter share has increased to 33% (OFFER Annual Report 1994 p.2). The trend is expected to be strengthened when Sizewell B comes on stream. Independent generators, often in combination with the RECs, have increased their capacity sharply, invariably with CCGTs, and are becoming an important force in the market.
The idea at the time of privatisation was that the distribution companies would have choice over their supplies by the workings of the pool. Electricity has special features which are reflected in the special nature of the pool market - essentially a spot market for electricity. In particular, it is almost impossible to store electricity which presents problems for coping with variations in demand over the day and night. The Central Electricity Generating Board operated by relying on the merit order of power stations, by which the lowest cost stations supplied the power throughout the day, but the higher cost stations supplied electricity to the grid when demand was high. It was not easy to preserve this feature of the system after privatisation, and the pool was devised in order to do so.
The pool is a market in which almost all electricity in England & Wales is traded, with the generators selling and the RECs buying. Each day, generators bid in their plant (on a set-by- set, half-hour by half-hour basis) for running on the following day. The lowest cost bids determine which power stations actually operate. The National Grid Company tries to schedule and despatch these generating sets, subject to constraints in the transmission system, to meet its forecasts of demand, including a margin for reserve, at the lowest cost based on the prices offered by the generators.
One complication was that the uncertainties of relying upon pool prices did not really suit either generators or RECs, so they devised "contracts for differences". These contracts basically offer hedging so that the fluctuations of pool prices are automatically ruled out in terms of what is actually paid for the electricity. The existence of such contracts is slightly controversial, since generators may be tempted to bid into the pool with prices below cost so as to undercut independent generators. They do not need to fear receiving too little revenue because the contract for differences automatically restores the price actually paid to a previously agreed level.
IV. Some Problems faced by the Regulator
In a perfectly competitive industry there would be no need for a regulator but such a model requires a large number of producers and there is no way that the privatised utilities can ever hope to conform to the model. It is a major weakness of economic theory that economists are unclear how to analyse competition between a small number of competitors.
It has often been argued that since regulation was an alternative to competition, increasing competition would leave the regulators with less to do. Experience so far of the regulated industries over the past decade does not appear to bear this out. The regulators have remained very busy and have tended to increase their intervention as they find that earlier attempts do not solve all the problems. It is true that electricity, starting with a structure containing competitive elements, has not experienced the trend towards structural change which has been present in the gas industry. There the question of whether British Gas should be broken up has never gone away and the company is under continuous pressure to lose market share. In electricity there have been no serious claims that the structure of the industry should be altered.
Two main criticisms of the privatised electricity industry have been heard. First, there are those who criticise the use of the market to determine the use of fuel to generate electricity and the "dash for gas". Critics argue that long-term investment decisions are not appropriately taken if the only consideration is short-term profitability, particularly in an industry where supplies of fossil fuels are limited. Extensive closures in the coal industry followed the policy of allowing the generators partial freedom to choose their fuel supply and to reduce coal burn. Once a coal mine is closed, it cannot plausibly be reopened except at vast expense. Other critics of the neglect of long-term investment decisions object that the new structure will not provide the financial guarantees that would enable a new nuclear power station to be built. These criticisms may or may not be valid, but it is not clear that the regulator has the power to intervene. The whole point of the reform was to allow the market to take decisions on energy supply rather than the Government or the civil service, and the regulator is not in a position to change that.
The second criticism of the privatised electricity industry, however, is very much a matter for the regulator. This is that prices under privatisation have remained much too high, so that the consumer has not derived any substantial benefit from the whole process.
V. The Control of Prices
The principle of the UK regulatory system is that prices rather than profits are regulated and that the price formula is fixed for a period of years, usually five. The point of both guidelines is to avoid the disincentive effect which can result from regulation. If a utility is told how much profit it is allowed to make, then there is no incentive whatever to increase its efficiency. Since most utilities are in uncompetitive positions, they can choose to have an easy life. Price regulation is supposed to be better, because the utility is told how much it must reduce prices or is allowed to increase them. It is, in principle, then allowed to make as much profit as it can. The basic system of price control followed by British Telecom was "RPI-X" - in other words British Telecom could increase the prices of a collection of telecommunications services by the amount that the retail price index increased, minus a certain percentage X. The same principle is applied to the regulation of electricity prices but in a far more complex way. Since the industry has been organised in three tiers - generation, distribution and supply - there are three levels of price which might be controlled.
Further problems abound. The difference between price and profit control is not so strict as might appear. The price control formula has to be renewed every five years or so, or else major discrepancies would be allowed to persist in some cases. Even in between the obvious benchmarks, there will be strong pressure on the regulator to intervene to tighten the price formula if profits are very high. That may not be the correct response, of course, and the management of utilities is always ready to point out how much it costs to invest in the network of electricity power lines (or gas pipelines, or telephone lines, or water pipes as the case may be). Since that has to be ultimately financed out of profits, too strict a control over prices may be self-defeating in the medium term. However, borrowing or a rights issue might be an appropriate way of financing a particularly high investment requirement covering a short period.
An additional problem is that any other change in regulation which will have profit implications will normally result in a revision of the price control formula. That is a particular problem in an industry, like gas, where the regulator has been unhappy about the structure of the industry - in that case the existence of a privatised monopoly. Too much regulatory intervention risks removing from the companies all incentives to become efficient. Too little intervention risks allowing companies to get away with excess profitability at the expense of the consumer.
If the regulator concentrates on changes in prices over time, he is tacitly assuming that the starting date saw a correct price level, which presumably means one giving a fair rate of return to the utilities involved. Therefore the regulator becomes almost inevitably pushed towards considerations of what is an appropriate rate of return. In the water industry, OFWAT has explicitly stated its requirements over rates of return. Concern over appropriate rates of return is not merely an academic point in the context of the electricity industry where prices increased before privatisation, so as to increase profits and make the sale more successful.
Yet the regulator's problem is immense. It is difficult to say how much profit (or return on capital) an enterprise should be allowed. Figures are available, of course, for various categories of private sector company, but there can always be disagreements as to which is appropriate. The average of all companies sounds reasonable, but then running a regulated utility with strong built-in monopoly elements is a safe occupation and should therefore be rewarded by a rate of return less than average - but how much less ?
Nor is it obvious how the rate of return should be calculated. In normal circumstances, the choice of accounting system may not matter provided that it is consistent. What matters is that companies pay the correct tax entitlement and that shareholders know how their dividends relate to profits. Under regulation, questions of the appropriateness of Current Cost Accounting or Historic Cost Accounting suddenly become very important since the choice may determine whether the utility is allowed to increase prices. Yet how do you value a power station built perhaps ten years ago to a design that would not be repeated if a new station were to be built today ?
Another difficulty arises over a potential conflict between the short-term interests of consumers and the longer term aim of encouraging competition. If the regulator uses his powers to keep prices low, there is no incentive for new producers to enter the market. Consumers, of course, are not worried by this because the low prices are what they want. However, in the absence of competition, there might be less innovation than would be desirable. On the other hand, if prices are kept up by the regulator so as to allow profits and encourage new entrants into the industry, consumers may legitimately feel that their interests are not being met.
VI. The Experience of Electricity
There have been two continuing problems for the DGES since privatisation. First, the structure on the industry was fairly competitive but did allow the two large generators, National Power and PowerGen a large share of the generation market, with possible effects on prices. The second problem is that prices increased sharply just before privatisation, and it is difficult to claw back such effects under the RPI-X system of price control. The DGES has been tackling both these problems this year.
One option for the structural problem would have been to refer the two generators to the Monopolies and Mergers Commission (MMC) - as British Gas has been - and the DGES used this threat to secure an agreement with the companies. On 11 February 1994, he announced that he had secured satisfactory assurances from them, to allow him to guarantee that they would not be referred to the MMC for at least two years (OFFER Annual Report 1994 p.9).
"First, National Power and PowerGen undertook to use all reasonable endeavours to dispose of about 4,000 MW and 2,000 MW respectively of coal- fired or oil-fired capacity by 31 December 1995. This will roughly double the present extent of independent generation in England and Wales, even including capacity under construction...Second, the two companies each agreed to bid into the Pool in such a way that annual Pool Purchase Price could reasonably be expected not to exceed certain specified levels. and to offer new contracts on a basis consistent with those prices...For the next two years, Pool Purchase Prices will be up to seven per cent lower in real terms than in the first nine months of 1993/94...I should emphasise that it is still my firm intention that generation should become a fully competitive market, not subject to price regulation or other forms of intervention."
However, there have been complaints over the deal from those not involved, objecting that the structure of the industry should not be decided by a private settlement. Nuclear Electric objected that they were not a party to the deal but they will lose from it, since they sell their electricity at pool prices, which are now to be artificially restricted. The Financial Times (20 June 1994) commented :
The deal satisfied few, other than the large users of electricity including ICI, who buy their power supplies at prices directly related to the pool price. However, the vast majority of consumers are unaffected by short term pool price changes since their supplies are covered by long term hedging contracts. They were, therefore, indifferent to Prof Littlechild's settlement with the generators. Independent generation companies, however, complained that the price cap would deter them from setting up new plants. Given that the deal was supposed to foster competition, this is a serious charge.
The other problem relates to the distribution side of the industry where the high profits of the RECs have attracted much comment and criticism.
A well-known study (G.Yarrow, British Electricity Prices since Privatization, 1992) notes that an increase in prices at the time of privatisation was not surprising.
What is, perhaps, surprising is the scale of the price effects. The estimates suggest that, on average, prices were up to 25% higher for domestic customers and up to 19% higher for industrial customers than would have been predicted on the basis of a continuation of pre-privatization trends. Moreover, the average figure for industrial customers conceals some quite major shifts in the structure of prices. Small industrial customers, for example, appear to have faced price increases of over 40% during a period in which, as a consequence of falling coal prices, they might have expected electricity prices to fall. It is safe to conclude, therefore, that privatization of the electricity supply industry has been accompanied by quite major distributional changes in the market.
The author notes that consumers had not benefited from privatisation at that stage - by the end of 1991 when the report was written. "Whether consumers will fare better in the longer term remains to be seen, but quite a major turnaround would be required to reverse the position reached at the beginning of 1992."
Another unfavourable study came from the Chemical Industries Association and dealt with large industrial users of electricity, who had suffered disproportionately from price increases since privatisation, according to the report. It concluded that the only large European country where prices had risen faster over the past six years was Italy. It concluded that UK electricity prices were 13% to 18% higher than the average of prices in Germany, France, Italy, Belgium and the Netherlands. Only German large users paid more for electricity than those in the UK (Financial Times 13 July 1994). Many large users wanted to bypass the pool completely but the DGES announced (14 July 1994) that a case had not been made out for significant changes so as to allow widespread trading outside the electricity pool.
The DGES is currently reviewing price controls on the distribution businesses of the RECs. Proposals are expected in the summer of 1994, to come into effect in april 1995. The DGES described this exercise as "the most significant of the price control reviews, since distribution costs and charges account for a much higher proportion of customers' electricity bills, and company profits, than transmission or supply costs and charges". It is widely expected that the DGES will recommend a tighter price cap formula to curb the REC's profits, but there are potential problems. There is a danger that such an exercise, openly influenced by complaints over high profits, might have a disincentive effect.
Another consideration is that if even one of the RECs is dissatisfied it can go to the MMC instead of accepting an imposed deal, thereby undoing the whole process. It has even been suggested by Dieter Helm, a regulatory expert, (Energy Utilities, May 1994 p.3) that such a referral might result in unfavourable comparisons between OFFER's methods and the "careful and detailed approach of Mr Ian Byatt, Director General of Water Services".
If the MMC were to investigate the industry, the terms of reference would be important. It is worth remembering that in the case of gas, the conclusions of a major review in 1993 were rejected by the Government. The MMC recommended that British Gas should dispose of its transport and distribution network, but not lose the monopoly right to supply small customers for some years thereafter. The Government decided not to split up British Gas, but to remove the monopoly for small customers much earlier. If the terms of reference were restricted to the workings of the price formula, such intervention would be unlikely, but if it were to extend further into, perhaps, the workings of the Pool, one cannot assume that MMC recommendations would be accepted.