First came the Pool, with its faults and virtues.

Now comes a wave of troubling takeovers.

What happens when retail supply opens up?

Much of the pressure to reform the electricity supply industry in the United States assumes that the United Kingdom's electricity experiment offers a proven model. Close examination, however, reveals that competition in generation is more apparent than real. Competition in supply (the retail segment) is not scheduled for the vast majority of consumers before 1998, and the industry is rapidly reintegrating and concentrating into a structure that may not be competitive.1

Six years of experience in Britain have demonstrated that the form of regulation, whether rate-of-return or incentive, is not the key factor. The promise that incentive regulation would end up simpler, cheaper, and a less dominating influence than rate-of-return regulation has not come true. In fact, it is now apparent that effective regulation of monopolies requires a regulatory body with the commercial know-how to understand a utility's cost base well enough to identify where costs can be squeezed (em and with the political power to enforce its will. High utility profits and the ease with which utilities still hoodwink the Regulator suggest that these conditions have yet to be fulfilled in Britain.

Industry Structure:

Less than Ideal

The Government's reform proposals assumed a four-tiered structure for the electricity supply industry:

s Transmission (high-voltage lines)

s Distribution (lines of 132 kV or less)

s Generation

s Supply (the purchase of electricity in bulk and its resale to final consumers, including meter reading and billing).

Transmission and distribution were assumed to be natural monopolies. Generation and supply were assumed to be potentially competitive.

An ideal structure would have stocked the generation and supply sectors with enough companies to ensure competitive behavior, while establishing a single national monopoly grid and a number of distribution companies with geographically defined monopolies whose performance could be compared. The companies involved in each of the four businesses would not have held interests in other electricity supply businesses because of the risk that they could exploit market power unfairly.

Nevertheless, a number of constraints on the Government, some self-imposed, worked against immediate implementation of such structure. First, any new companies had to be salable to potential shareholders. Second, the new system had to be completed well within the span of office of a Government, effectively only three to four years, since any business half-finished at election time may well be abandoned. Third, the Government had committed itself in its election manifesto to promote nuclear power, so any new structure had to accommodate the special needs of nuclear. (In the end, the attempt to privatize nuclear failed, leaving a state-owned and subsidized nuclear sector.) Finally, the reliability of the electricity sector had to be maintained, so a number of transitional measures had to be included to reduce the risk that the system would fail.2

Previously, distribution and supply were integrated and carried out by 12 regional, state-owned, monopoly companies. They bought all their power from the Central Electricity Generating Board (CEGB) at standard bulk tariffs over which they had little influence. Splitting up these companies was considered too great a risk, so they were privatized intact, with some accounting separation of the two component businesses. Now known as Regional Electricity Companies (RECs), these companies were allowed to own as much generation capacity as they wished, but could contract for no more than 15 percent of their power requirements from their own plant.

A priority called for separating transmission from generation, because many thought the CEGB had exploited its position as both a generator and transmission owner to price other generators off the system. However, a company solely devoted to transmission would appear unfamiliar and prove difficult to market to potential stockholders. Hence, the Government created the National Grid Company (NGC), to be jointly owned by the RECs and to provide them with substantial low-risk income during much of the transition to competition. To prevent the RECs from exploiting their ownership of NGC, the government restricted their ability to influence NGC policies.

Generation:

Far From Competitive

Competition in generation received the most attention at the time of privatization (em and would be achieved by creating a Power Pool. All generators wanting to use their plants must now place a bid, 24 hours in advance, that applies for each half hour of the next day. Price decides the winning bids and all successful bidders receive the cost offered by the highest successful bid. Only plant bid successfully into the Pool can be used; however, generators cannot be compelled to bid their plant, nor constrained on the price they can bid. The RECs must purchase their power from the Pool.

To smooth the transition from monopoly to competition, the Government imposed a number of contracts on the new companies to guarantee an orderly market for at least the first three years. Chief among these were contracts between the state-owned coal mining company and the two privatized generators. These contracts maintained demand for coal, which contributed about 80 percent of CEGB's generation at the time of privatization (slightly below historic levels). Prices fell significantly lower in real terms, however, to bring British coal prices more in line with world coal prices. While reducing the power of the principal miners' union lay clearly within the Government's agenda,3 a precipitate collapse of the industry was feared if the generators were left free to import as much coal as they wished. To protect the market of the generators from new entrants using cheaper fuels, the RECs were given contracts for power supply from National Power and PowerGen. These contracts made up the vast majority of power needs for the RECs, along with contribution from nuclear plant. To protect market shares for the RECs, choice in power supply was extended only to those consumers with a maximum demand of over 1 megawatt (Mw).

The contracts between the RECs and the generators (the so-called "Contracts for Differences," or CfDs) effectively rendered the Pool price irrelevant. Generators had to place a successful bid with the Pool, and the RECs had to purchase from the Pool, but the CfDs meant that the difference between the Pool and the contract price was paid by the generator to the REC, or vice versa. In short, the Pool price had no impact on the actual price paid by the RECs to the generators.

As events unfolded, the threat to British coal did not come from imports, but from natural gas burned in combined-cycle plants, which offered certain strategic advantages over coal-fired plants, beyond their modest cost edge. Gas-fired plants allowed generators to meet targets for acid deposition gas emissions without retrofitting flue-gas desulfurization equipment at coal plants. The RECs could build generation capacity, reducing their reliance on the generation duopoly. And the new markets for gas allowed the oil companies to exploit newly discovered reserves in the North Sea. Generators ordered a huge amount of new gas-fired capacity (about 10 gigawatts (Gw)) during in the first two years following privatization, split approximately equally between independent power producers (IPPs) and the duopoly. In reality, however, the IPPs were far from independent; all were owned largely by one or more of the RECs. They operated with matching 15-year gas and electricity supply contracts (again, CfDs), compelling their use as base-load capacity and insulating their prices from market forces.

By the time the initial three-year coal contracts were due to expire, coal demand appeared on the verge of collapse (em mainly because of the new gas generation, but also because of an unexpected increase in nuclear generation. (Under the new rules, any nuclear generation had to be purchased.) Hence, much of Britain's deep-mined coal capacity lay under threat of closure. In the resulting political storm, the Government intervened to broker contracts between the coal company and the generators, which ran until 1998, for about half the volumes used at time of privatization, at prices that continued to fall. These contracts were matched by further CfDs between the RECs and the two large generators.

All these events guarantee an ironic result: From the date of privatization to at least 1998, the bulk of electricity will have been bought and sold at prices that bear no relationship to Pool prices or to prices set by any process remotely resembling competition. The irrelevance of the Pool price has led to wild fluctuations that often bear little apparent relation to supply and demand for power or the cost of generation.

While an unexpectedly large number of new generation companies emerged, all were protected by CfDs. Thus, the Pool price was almost invariably set by the two large generation companies. The Regulator found this situation disturbing enough to force the two large generators to agree to ensure an average Pool price of about 2.5 pence per kilowatt-hour for the two years starting April 1, 1994. The mere fact of such an agreement proves that the Pool lacks true competition.

Retail Supply:

Still Problematic

Competition in retail supply was phased in to protect the markets of the RECs. Consumers with a maximum demand of more than 1 Mw were able to choose their supplier immediately in 1990. This ceiling was lowered to 100 kilowatts (Kw) in 1994, with full eligibility for all demand levels in 1998.

The competition in retail supply introduced in 1990 posed no major risk because it involved only about 5,000 eligible customers. They were easy to target; their bills were large enough that even a small reduction could yield worthwhile savings. Little chance existed for any emerging suppliers, RECs, or the two large generators to undercut each other significantly without incurring losses. After all, the Government had engineered the cost bases of the two generators to be almost identical. The RECs had no effective alternative but to buy from these two companies. Nevertheless, the new market was vigorously fought over. Most large consumers changed suppliers or negotiated lower prices from their existing supplier, creating the impression of a competitive market.

The lowering of the eligibility ceiling to 100 Kw marked a much more daunting change, however. Some 45,000 new consumers

became eligible for supply choice, creating a vast data-processing problem. To set proper charges for distribution services required a meter that could transmit consumption data on a half-hourly basis. The first year after opening up this market was chaotic. Nevertheless, many consumers did change suppliers or negotiate lower prices. The practical problems can likely be sorted out in the long term. The cost of metering, marketing, and data processing are low enough compared to even the smallest bills in this market sector to make competition worthwhile.

However, until competition in retail supply becomes available to all consumers, the new market cannot be termed satisfactory. Suppliers may well offer sub-economic terms to large consumers to maintain the volume of their market, passing on extra costs to their captive consumers. The Regulator will find it difficult to prove this subsidy, because, in a network industry such as electricity, allocating costs between different groups of consumers in a network industry involves difficult judgments. Changes in the balance of tariffs can always be explained by claims that they remove cross-subsidies.

Other Sectors:

The Grid, Nukes, and IPPs

The Government has met its objectives unequivocally in at least one area: opening up access to the wires so that ownership of the high-voltage transmission grid or low-voltage distribution network offers no competitive advantage to suppliers or generators. The attractions of owning these sectors now lie purely in perceptions of how profitable these businesses will be. Once the Regulator obtains a better grasp of the cost base and is able to impose a more stringent regulatory regime, these sectors will become low-risk businesses with correspondingly low, but secure, returns for investors.

Other anomalies remain, however.

To reduce public ownership of the nuclear plants, the Government has split the assets into two parts: 1) plants that are potentially salable (em those being the seven Advanced Gas-Cooled Reactor (AGR) stations and the Pressurized Water Reactor (PWR) (em and 2) the old stations, the Magnoxes, which are too near the end of their useful lives to be sold. On April 1,1996, it transferred the new plants to a new company, British Energy, which, it is hoped, will be privatized this year. The older plants were moved to another new company, Magnox Electric, which is planned to be absorbed into the state-owned fuel-cycle company, British Nuclear Fuels. If British Energy is sold it will not pursue any new nuclear interests, and instead will become a large generating company with market power similar to National Power and PowerGen.

The emergence of IPPs after 1990 appeared the vindicate the Government's belief that competition would grow to break the generation duopoly, but in reality, while the IPPs have reduced the market shares of the two large generators, they haven't contributed much in developing a competitive market.

Ownership of the IPPs remains dominated by the RECs that signed 15-year gas supply contracts matched by electricity supply contracts. Thus, these IPP plants can afford to bid zero into the Pool to ensure their dispatch, knowing that they will receive a price equal to the long-term contract price. In effect, it is the consumers (most of whom will remain captive until at least 1998) who bear the risk for these IPP plants. In fact, the Regulator acknowledged that these plants have played little role in adding competition to the generation sector in his decision to impose a price cap on the Pool and to force National Power and PowerGen to sell 6,000 Mw of coal-fired capacity. As the RECs quickly filled their 15-percent quota for owned generation, and as the full opening up of the retail supply market (in 1998) has neared, the RECs began to lose their power to shift the risk of building new plant to captive customers. The flow of IPPs built on such terms quickly dried up.

New Obstacles:

Mergers and Takeovers

Activity in mergers and acquisitions did not begin in earnest until 1995, mainly because the Government held so-called "Golden Shares" in the RECs, which effectively prevented any takeovers. But when that restriction was removed, the market clearly reacted. It judged that the regulatory formulas would allow the RECs to earn large profits in a low-risk business. As a result, the RECs became targets for takeover. By April 1996 only three of the twelve RECs had not fallen prey to takeover bids.

The deals can be divided into four categories: conglomerate takeovers by diversified companies, horizontal takeovers by foreign utilities, horizontal integration into other utility services, and vertical integration of generation and supply. The first three categories raise issues of regulation, such as ensuring that profits are not siphoned out of the businesses (em particularly the monopolies (em either into competitive businesses or overseas. The issue of foreign ownership also raises an emotional reaction: Ownership of key structural industries ought to remain in national hands so that the companies can be more easily controlled.

It is the threat of vertical integration that raises questions of principle. Strict separation was never enforced in the new structure: The RECs quickly took advantage of their ability to contract for 15 percent of their power requirements from sources owned by themselves, and the generators competed vigorously in the supply markets. Separation was further eroded when an integrated Scottish electricity company took over an English REC. The Government allowed the takeover to proceed because it was not viewed as a major encroachment. (The Scottish system is run largely separately from the England and Wales system (em along fully vertically integrated lines (em with trading between the systems only at the margin.)

The next step toward vertical integration occurred in Autumn 1995, when Eastern Electricity (an English REC) agreed to buy 2,000 Mw of coal-fired plant from PowerGen (the Regulator had forced PowerGen to sell the capacity). In fact, Eastern had already made a major commitment to generation and had recently been taken over by Hanson, a diversified, multinational company. In April 1996, National Power agreed to sell Hanson the 4,000 Mw of coal capacity that it had been forced to sell. If these sales are finalized, Hanson will own an integrated generation and supply company that would control about 14 percent of the generation market.

The deintegrated structure faced its greatest challenge with PowerGen's bid for Midlands Electricity, followed swiftly by National Power's bid for another REC, Southern Electricity. At this point, the Government felt compelled to act, referring the bids to the Monopolies and Mergers Commission (MMC), a semi-autonomous body that investigates issues of monopoly and merger, reporting to a Government Minister. The Minister is obliged to publish the report and to comment on its findings, although he is not obliged to adopt the MMC's recommendations. The Minister made it clear when he referred these takeovers to the MMC that vertical integration was not at issue, but rather the size and market power of the companies created.

The situation was further complicated by a possible takeover of National Power by a U.S. utility, The Southern Co., which had already taken over an REC, South Western Electricity Board (SWEB). Faced with the possibility that foreign owners would take over the largest generation company, and in so doing become the largest distribution and supply company, the Government chose not to accept the MMC's recommendations and disallowed the takeovers. In fact, the Minister made it clear that the Government's golden share in National Power and PowerGen would be invoked to block the takeover. [Although the REC golden shares had a fixed time span (to March 1995), the generator golden shares are open-ended, until the Government chooses to relinquish them.] However, the Minister reemphasized that the problem was not with vertical integration, but with timing and the size of the companies created. Large integrated companies, the Government claimed, might jeopardize the introduction of competition to the residential market in 1998.

The structure of the electricity supply industry now has become somewhat anomalous. The Eastern Group will boast a generation market share of about 14 percent, compared to PowerGen, whose share will fall to about 15 percent. It now seems possible that, sooner or later, by a process of REC takeovers and mergers and redistribution of generation assets, the industry will become dominated by a handful of vertically integrated generation and supply companies.

Achieving the Vision:

Increasingly Improbable

The Government's vision of competition in generation was that 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 new meters are not required, that they can assume, rather than measure, a consumer's demand profile. That shortcut would remove an important market mechanism: the ability of consumers to shift their demand patterns according to price signals. Nevertheless, some consumers from rich districts with higher-than-average consumption and good records of paying bills will remain attractive to new suppliers, so some sort of market may emerge on the basis of "cherry-picking" strategies. But where would this leave low-volume consumers in poor areas? If the distribution and supply businesses should separate, leaving no retail supplier with a geographic locus, who would serve as the supplier of last resort, and for what compensation?

It is therefore difficult within the present structure to see how full competition would emerge. Small customers would likely end up paying for competition in other market sectors.

A Dynamic View:

From the Bottom Up

Favoring a less static view, some have speculated that new entrants might find value in getting access to full details about a geographically concentrated set of consumers and use this information to sell gas, water, cable television, and other home shopping services. Or, perhaps supermarkets or gasoline companies might try to buy loyalty to their products by offering discounts on electricity sales.

These new dynamic structures hold attractions. A market driven from the bottom up would take much more account of the requirements of consumers, as represented by powerful buyers such as oil companies and supermarket chains. Such companies would prove much more aggressive than individual consumers in seeking out the lowest package of generation costs, which would reduce the risk that residential consumers would end up paying for competition in large-volume markets.

An integrated, competitive system may therefore prove viable. But would it be preferable to an integrated, noncompetitive system? If integrated competitive suppliers were allowed to retain the advantage of a cheaper generation portfolio, a day-to-day Pool would be irrelevant or only of marginal significance. IPPs might also have no space in such a competitive system. In the past, IPPs were squeezed out by lack of access to the system; in this scenario, they would lack a final market for their power. Moreover, competition authorities would require extremely fine judgment to determine how many suppliers are sufficient to guarantee

competitive behavior, and clear guidelines to prevent the concentrations that would inevitably be sought by the largest companies. An integrated competitive system would also require determined actions to break the local de facto supply monopolies.

If moving to such an integrated competitive system is the British Government's intention, with clear safeguards against unchecked market power, then it shows no sign of acknowledging it. The British Government seems too credulous of the empty rhetoric of takeovers and mergers. The existence of "synergies" and "economies of scale," and the promise of creating "world-class British companies," seem to be accepted uncritically. A more likely interpretation is that the new structure failed either because it was infeasible or the Government lacked the political will to enforce it, so that the industry now lies at the mercy of the players, which inevitably maintain a strong interest in stifling competition, because real competition increases risks and reduces profits. t

Steve Thomas is a senior fellow in the Science Policy Research Unit at the University of Sussex in the United Kingdom.

1. For a fuller account of the history of the British electricity supply industry and its restructuring, see A.J. Surrey (ed.) The British Electricity Experiment, Earthscan: London (1996).

2. The structure described here applies only to England and Wales. Other, less competitive, structures were adopted for Scotland and Northern Ireland.

3. Several former ministers in Thatcher Governments have stressed the deep animosity between the National Union of Mine Workers (NUM) and the Government and the Government's strategic objective of breaking NUM power. See, for example, N. Ridley, My Style of Government, Hutchinson: 1991; P. Walker, Staying Power, Bloomsbury Publishing: 1991; C. Parkinson, Right at the Centre, Weidenfeld & Nicolson: 1991; and N. Lawson, The view from No. 11, Bantam Press: 1992.

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