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Electric Reform in Great Britain: An imperfect Model.

Fortnightly Magazine - June 15 1996

the Power Pool would supply continuous competitive pressure to keep fuel and overhead costs down throughout the life of the power station. So far, the Power Pool has not fulfilled such a role. Instead, long-term, rigidly priced bilateral contracts form the rule. If contracts were short term (about a year) and set with reference to price signals from a competitive market-clearing Pool in the way that, for example, the oil spot market works, the generation market could be described as fully competitive.

However, a fully competitive generation sector presents two problems. First, does it offer security of supply? Second, does it offer a sufficiently secure investment environment for financing new power stations?

In a free market, plant owners will retain or retire plant on the basis of whether they expect to make money, not whether the plant is needed to keep the lights on. This fact means that any regulatory intervention designed to guarantee that capacity is available would run counter to the principles of a free market. Moreover, the building of a large power station would be difficult to finance if its use and the price it would receive for its output could not be forecast more than, say, a year in advance. Financing for power stations would thus require a large risk premium or be limited to companies with captive customers or companies with such a dominant market share that the risk could be absorbed. If this is the case, attempts to improve the competitiveness of generation may occur at the expense of reliable supply.

Competition in the retail supply segment has been feasible so far because the bills for eligible customers remain large relative to the cost of winning new customers. But this ratio will not hold true for residential consumers. A typical annual residential bill might total £400: £216 for generation, £100 for distribution, £40 to subsidize nuclear power, £24 for supply, and £20 for transmission. Any supplier would have no choice but to levy the cost of distribution, transmission, and the nuclear subsidy. Thus, only £240 is open to competition.

Effective competition in generation will make it difficult for one retail supplier to undercut another on power purchases, which leaves only the profits on a gross annual income of £240 to pay for the cost of installing a new interactive meter. Optimistically, this cost might fall to £50 (em to pay for an advertising campaign to attract new customers, and to fund the discounts necessary to get consumers to switch. Experience from telecommunications suggests that the cost of advertising and discounts may come in around £100. It also suggests that residential consumers tend to remain loyal to incumbent suppliers even when cheaper alternatives are available. The potential savings of choosing an alternative supplier are often too small and difficult to calculate, given the complicated tariff structures that have been introduced, for consumers to believe it worth their while to investigate the possibilities.

New retail suppliers are unlikely to incur heavy costs to win such small potential profits. Suppliers are now attempting to convince the Regulator that the