British Electricity Distributor Industry - Term Paper Example

Analysis of British Electri Distributor Industry Module Table of Contents Introduction 2 Part1: Analysis of the Market Structure 4 Overall Market Structure 4 Reasons for the Oligopoly Structure 5 Possible Future Structure of the Industry 6 How the Structure Affects Strategy Decisions 7 Part 2: Analysis of the Contribution of the Sector to UK Economy 8 Source of Employment and National Income 8 Providing Power for Domestic and Commercial Use 10 Bolsters Economic Growth 12 Part 3: Critical appraisal of sustainability targets on business plan of UK Power Networks 13 Overall Sustainability targets on the Business Plan 13 Reliability and Availability 14 Customer Service and Customer Satisfaction 15 Social Responsibility and Environmental Protection 16 Conclusion 17 References List 18 Appendices 20 Introduction The electricity distribution industry includes firms which distribute low-voltage electricity from high-voltage transmission lines to the end consumers of the electricity. They operate electricity distribution networks in order to allow consumers to receive electricity. Electricity distribution companies in UK do not produce electricity, they only distribute it. The industry product is electricity distribution. The revenue produced by the industry is £6 billion. Its annual growth is 6.7%, and it employs 13,023 employees (IBISWorld, 2014). There are seven electricity distribution businesses in the UK. Other than enabling consumers to access electricity, electricity distribution industry also creates employment, enhances investment and promotes economic growth. This report examines the structure of electricity consumption industry, including the firms that make up the industry and their market share. It also explains the reason for the chosen structure. Furthermore, this report analyses the contribution of the electricity distribution industry to the economy. It also provides a critical analysis of sustainability targets on business plan for the industry as well as the factors that contribute competitive advantage for the electricity distribution industry in UK. Part 1: Analysis of the Market Structure Overall Market Structure The market structure of UK electricity distribution industry is an oligopoly. An oligopoly is a market structure which involves the domination of a few firms in an industry, although smaller firms with small market shares may exist in the market. In this case, a few firms may be concentrated. The UK electricity distribution industry consists of six large electricity distributors with a total of 90% market share. The remaining market share is held by smaller networks owned and operated by Independent Network Operators (IDNOs) which operate within the areas covered by the larger firms. The market shares of major British electricity Distribution Networks (DNOs) is divided by regions, as shown in appendix one. Each serves specific region. The six distributors by region include: UK Power Networks, Western Power Distribution, SSE Power Distribution, SP Energy Networks, Northern Powergrid, and Electricity Northwest. In a competition newsletter of 2014, UK Power Networks (UKPN) analysed the market share of its distributors in its designed regions. The newsletter categorised the market share into three: Eastern Power Networks plc (EPN), London Power Networks plc (LPN) and South Eastern Power Networks plc (SPN). The market shares for the three distributors are shown below: EPN 35% LPN 38% SPN 33% As shown from the table above, it is clear that there are no big market share margins or differences between the three major UK Power Networks. This proofs the fact that UK Power Distribution industry is an oligopoly. An oligopoly market is characterized by interdependence in which each firm is so large that its actions affect the conditions of the market. From the table above, the firms in the electricity distribution industry are large and the action of one company affects the market conditions. Furthermore, oligopolies can either have differentiated or homogenous products. Reasons for the Oligopoly Structure The main reason why the industry is oligopolistic (imperfect competition) is because there is a high barrier to entry by other firms due to the high investments needed. The materials needed to carry electricity from high voltage transmission to lower voltage require a large amount of investment. Having invested heavily on the capital-intensive business, incumbent firms usually develop economies of scale which also act as a barrier to entry. Other factors that raise the barriers to entry in electricity distribution companies include licensing from the government, patents and strategic actions of the incumbents. Ofgem (2014) suggests that electricity distribution companies in UK are required to have a licence which contains conditions such as restricted amount of revenue required for distributors to recover from customers. A study by Spence (1977) demonstrates that capacity and other investment efforts are effective barriers to entry because they are irreversible and involves a great deal of commitment to the industry. Investment in electricity distribution industry involves a high capacity and may not be reversed once a company starts to invest in the industry. The electricity distribution industry also requires a complex technology which cannot be achieved by many companies. The transmission requires aluminum or copper wires, grid system, transformers and other key technologies that require a lot of costs in order to set up. High levels of technology act as barriers to entry by new firms because it requires experience and extensive research and development in order to provide the right technology needed in the industry. Ferrer (2013) suggests that oligopoly have a good knowledge of prices and technology, which potential entrants into the industry lack. Existing firms also have skills about the technology used in transmission and distribution of electricity, acting as barriers to entry by firms without those types of skills. Spence (1977) argues that this capacity in terms of technology and high-level investment in an oligopoly makes a new entrant unprofitable. Possible Future Structure of the Industry The future structure of the British electricity distributor industry may be affected by the eight-year price control implemented by the government through the Office of Gas and Electricity Markets (OFGEM). The price control may lower the barriers to entry in the industry, and cause increased competition in the market structure in the industry in future. In 2008, Ofgem CEO Alistair Buchanan hinted that the UK electricity distribution industry was becoming more competitive as firms set different prices for their services (The Telegraph, 2008). Firms gain and lose significant market share in the industry. Others introduce innovations to boost their business. There is a likely change in the electricity distribution industry that collusion between existing large firms may occur, although this is more theoretical than real. Colluding may help the large firms in the industry to keep prices the same across the industry, maximise joint profits and control the market. The Telegraph (2008) suggests that Ofgem has called for the liberalisation of electricity distribution due to the signs of possible collusions in the electricity distribution industry. Liberalisation was enhanced through the separation between distribution networks and suppliers. Prices were rising significantly in 2008 across distribution networks, and just recently the government implemented the price control to last for the next eight years, preventing chances of collusions in the future. The price control can correct the oligopoly collusion as shown in the diagram below. MC Po Oligopoly price (collusion) Pc Competitive price (under price control) MR=MC D Qo QC From the diagram above, companies in the electricity distribution industry may collude to offer high prices Po at low quantity Qo when Marginal revenue equals marginal cost, but when Ofgem restricts the prices at Pc with an aim liberalising the industry, the competitive quantity will be offered at Qc where demand is equal to marginal cost. This is where the industry is headed in the future if the price control is implemented effectively for the eight years. However, the market share and capacity held by the existing large firms in the British electricity industry may not allow entry of new firms; but for the large firms to hold their market position and deal with competition from smaller independent power networks, they need to develop differentiation strategy and build their capacity around new technologies and improved reliance. How the Structure Affects Strategy Decisions Strategic decisions of an oligopoly depend on profit maximization. Firms provide offers in terms of products and services which maximize profits (Ferrer, 2013). Therefore, the strategic decisions of oligopolies are based on making the highest profits at the least prices. Oligopolistic firms in the British power distribution industry take advantage of the absence of entry to make large profits by offering high prices to cover the high capacity and costs of investments involved. In this case, firms in the industry use pricing strategy to achieve their profitability objective. However, price controls by the government may cause new strategies. As a result, companies will start competing through non-price strategies. For example, UK Power Networks is now implementing its business plan based on electricity price control over the next years (UK Power Networks, 2015). The business plan involves efficiency savings and improvements in reliability and customer service, which reflects a form of differentiation strategy. Within the oligopoly market, companies produce similar products that are differentiated in a few ways. For UK Power Networks, differentiation is achieved through reliability and customer service. Firms in the British electricity distribution industry also use strategies that can prevent entry. One of the strategies is to choose the right capacity designed to discourage entry. In this case, the strategic purpose is to hold excess capacity in the pre-entry period (Spence, 1977). Following the price controls by the government that affects pricing strategy, UK Power Networks seeks to develop a new investment programme to deliver the required capacity in its regions and discourage potential entry into the industry. This is a form of generic competitive strategy which involves the use of resources to beat competition. Part 2: Analysis of the Contribution of the Sector to UK Economy Source of Employment and National Income The electricity distribution industry of the UK has provided employment to 13,023 employees across the country. Employment is one of the key objectives of the government, and the electricity distribution networks can help in achievement of this objective. Employees are central to the success of electricity distribution. They operate regulated infrastructure throughout the country enhance growth of the industry. In this regard, employees in the industry need to be highly skilled, high performing, and experienced in order to ensure constant distribution of power with little power shortages and large coverage of the country with electricity distribution. Electricity distribution workers are hired by electricity distributors to build, install and maintain electrical equipment, distribution systems and machines in order to ensure constant supply of electricity to homes (My World of Work, 2015). Some of the areas of specialty for electricity distribution worker include: electrical fitters, cable jointers and linespersons. These workers work together to ensure that communities and businesses get access to electricity needed to run various activities in the country and boost the economy as seen in the next subsection. Employment of people contributes to increased income in the country in two ways. First, the workers earn income which is used to support their consumption needs and saved for future investment. Consumption boosts the economy by increasing demand of products and services in the economy. By paying employees good salary, electricity distribution industry in the UK increases their purchasing power, leading to increased demand for products and services. As a result, increased demand of products and services causes increased production in the country, eventually causing increased GDP in the long run for the country. In terms of savings and investment, electricity distribution workers and managers save their income and later use them to invest in small businesses in other sectors of the economy (My World of Work, 2015). Those small businesses may then earn profits and income, contributing to the overall GDP growth of the country. The income of employees is also taxable by the government, increasing government revenue that can be used for development projects e.g. infrastructural development. Secondly, employees are the important stakeholders in the enhancement of profitability in electricity distribution companies. They play a key role in various activities of the industry firms, causing improved productivity, efficiency and reliance in the companies. In the long run, these positive aspects cause an increase in profitability of the company. For example, the revenue of electricity distribution industry in UK was £6 billion in 2014 (IBISWorld, 2014). The companies within the industry then pay taxes to the government using the profits they get, and use the other profits for growth and expansion. This leads to increased demand for workers, and income multiplies and causes a growth in the country’s overall GDP. Providing Power for Domestic and Commercial Use The Electricity distributor industry also helps communities and societies by distributing power to their homes, schools, offices, manufacturing and processing firms, entertainment places and other important sectors of the economy. Electricity distributors help people to run their daily activities successfully with the distribution of electricity (Scottish and Southern Energy Power Distribution, 2014). For example, businesses need electricity to support their computers and record their data. Factories also need electricity to run large machines and produce products for consumption by local communities and international community. These functions show that electricity distribution networks are essential for firms to promote good welfare and high standard of living through coordination of activities and production of goods and services. For instance, UK Power Networks which is UK’s largest power network distributes electricity to 7.8 million homes and businesses within East England and South East. Electricity distribution firms in UK provide electricity companies with what they want as part of the regulatory requirements of Ofgem. A new framework of price control called RIIO was introduced in 2015 to cover a period of eight years until 2023. This framework is linked to incentives, outputs and innovation to ensure that firms in the industry provide customers with reliable services. Ofgem rewards distributors that focus on customer wants and use innovation to meet the challenges of customers (Scottish and Southern Energy Power Distribution, 2014). The focus on reliable output for customers ensures that electricity consumers are able to run their energy-reliant projects successfully in order to enhance their lives and promote productivity in the community. Electricity distribution industry in the UK ensures that citizens of the country get easy and reliable access to electricity power at home and businesses for various activities including heating, computing and lighting (Government of UK, 2010). The electricity generating companies also balance between generating capacity margins and total demand of electricity through the National Grid (Government of UK, 2015). In simple terms, the distribution operators balance the system by determining the level of electricity demand and matching it with supply. The electricity distribution industry plays the role of matching supply to demand by increasing or lowering power generation. Power distributors also ask their clients to use voluntary mechanisms of demand reduction. In this case, large electricity users are encouraged to reduce their demand in order to help in balancing the system. Maintaining UK Energy Security and Protecting the Environment Distribution of energy by converting high-voltage power into low-voltage is an important role of electricity distributors in UK. This distribution in a reliable and sustainable manner enables the population to avoid the use of high-energy fuel. In this regard, the government of UK suggests that electricity distributing companies are very important in achieving the energy and climate change objectives of the country (Government of UK, 2015). Electricity distribution industry in UK was privatised in order to enhance the efficiency of electricity distribution. With the right distributor of electricity, customers are able to get energy that is generated from renewable sources. This does not only improve energy efficiency and energy saving, but also contributes to reduction of the effects of climate change. Electricity distribution industry in UK helps in reduction of climate change by balancing the demand and supply of electricity (IBISWorld, 2014). When the energy needs of customers are fully met by the distributors, people do not have to use non-renewable sources and which does not only waste energy but also lead to emission of greenhouse gases, leading to climate change. The government has developed an eight-year plan of price control that incorporates low-carbon requirements (UK Power Network, 2013). Electricity distribution industry is therefore important in lowering the level of carbon in the environment, leading to the achievement of government objectives on climate change. Bolsters Economic Growth Essential sectors of the economy including agriculture and manufacturing require a large amount of energy in their production. Electricity distribution industry ensures that they get enough and reliable energy on time by distributing electric power as a source of energy. These sectors are therefore able to engage in production effectively and produce sufficient goods and services in the economy. By balancing demand and supply of electricity, electricity distributor industry ensures that companies in various sectors utilise electricity efficiently to avoid wasting economic resources, while at the same time producing goods and services. In other words, essential sectors of the economy require effective electricity distribution in order to utilise resources efficiently in the production of goods and services. This leads to increased productivity and economic growth in the economy. Part 3: Critical appraisal of sustainability targets on business plan of UK Power Networks Overall Sustainability targets on the Business Plan UK Power Networks is one of the six large electricity distributors in UK. It distributes electricity to East of England. Its business plan for electricity distribution covers the period between 2015 and 2023 in response to the eight-year price control by Ofgem (UK Power Network, 2013). The final draft of the business plan was submitted to the regulatory body in July 2013. It provides detailed information about the planning process, outputs delivered to customers, and current cost and revenue estimates. The business plan also provides details of the company’s approach to sustainability. In the business plan, UK Power Networks demonstrates commitment to the triple bottom line of sustainable development – planet (environment), people (society), and profit (economy). Sustainable development is a key pillar of strategic management (Karagülle, 2012). The term was developed by the World Commission on Environment in 1987. The commission defined sustainable development as a form of development that focuses on meeting current needs while taking care not to compromise the needs of future generations. The triple bottom line requires organisations to pursue profits while at the same time pursuing the interests of the environment and the society (Sriram et al, 2013). UK Power Networks serves the interests of different stakeholders including customers, employees, stakeholders, the government, the community and the environment. The sustainability targets of the company are indicated in the output categories provided by Ofgem including corporate social responsibility, environment, safety, customer satisfaction, reliability and availability, and connections (UK Power Networks, 2013). UK Power Networks focuses on achieving top third position in reliability and availability and customer satisfaction performance. Another strategic target is to reduce network risk for health and load index. In terms of connections, the company aims at improving the time to connect every year and boost the investment for distributed generation. Social responsibility of the company is committed to creating value for money, consideration of optimization of distribution networks in investment decisions, and increased investment on vulnerable customers. The environmental target of the company is to achieve top third position in Business Carbon Footprint (BCF) league table. In terms of safety, UKPN continues to target zero harm on people in the community and creation of public safety awareness (UK Power Network, 2013). The possibility of success of these sustainability targets can be assessed by examining some factors that affect the triple bottom line as shown below. Reliability and Availability The sustainability target of the company in terms of reliability and availability is to become top third in terms of IIS performance. IIS refers to the Interruption Incentive Scheme which shows the amount of annual rewards or penalties that result from the measure of performance of DNOs against a given target for the number of customers who have experienced interruptions per 100 customers in a year and the number of minutes lost per customer (UK Power Network, 2013). Another focus in this category is to reduce network risk in Eastern Power Networks for Health Index (HI) and Load Index (LI). Reliability and security of power supply is an important way of ensuring that customers do not experience interruptions which may affect their activities negatively. The top third position targeted by the company is a SMART objective because the company does not rush to target position one, knowing that it is difficult to minimize interruptions completely over time. However, the company shows commitment to enhancing reliability and availability of service in order to win the trust of customers. This is a way of serving the interests of customers while at the same time differentiating products for the purpose of obtaining a competitive edge against the rise of small distributors in the industry. The company also targets lower risks in terms of health, which means that it is committed to achieving the societal aspect of the triple bottom line. In this case, the company is required to take care of the society (people), and keep them safe and healthy. Karagülle (2012) suggests that sustainable targets should have reduced negative impact on human health. Therefore, as the company attempts to minimize risks on human health, it means that it is committed to high sustainability. Customer Service and Customer Satisfaction In terms of customer satisfaction, UK Power Networks is focused on achieving top third position in customer satisfaction performance measured as Broad Measure of Customer Satisfaction (BMoCS). This measure involves customer satisfaction survey, complaints metric and stakeholder engagement. UK Power Networks intends to conduct customer survey on customers who contact the company for complaints such as power cut, connection or general inquiry (UK Power Network, 2013). The speed and effectiveness of the company when responding to customer complaints will also determine its customer satisfaction. Achieving customer satisfaction over the business plan period of eight years will indicate that the company provides customer services and products that add value to the customers; hence contributing to the triple bottom line. Customer service is an essential element for achieving customer satisfaction (Kolk and Tulder, 2010). If the company achieves its target of speed and effectiveness when responding to customers then it achieves high customer satisfaction. Engaging positively with stakeholders also improves the satisfaction of customers, which shows the perception of customers concerning the level of customer service offered by the company. Social Responsibility and Environmental Protection Social responsibility refers to a theory which suggests that firms and individuals have the obligation to act in a way that they benefit the society at large because the society has allowed them to operate in the community (Abdulrazak and Ahmad, 2014). UK Power Networks focuses on creating value for the money used by customers in the consumption of electricity distributed by the company. Social responsibility of the company involves being conscious of the environment and enhancing safety of various members of the community (UK Power Network, 2013). These are analysed below. The business plan of UKPN targets top third position in terms of Business Carbon Footprint (UK Power Networks, 2013). This is a reputation incentive introduced by Ofgem to encourage electricity distributors in UK to take into account the impact of their actions on the environment. Clearly, this reflects the “planet” factor in the triple bottom line. For sustainable development, organisations need to ensure that they reduce emission of carbon gases or carbon footprints which may cause a negative impact on the environment. The chief executive officer of UK Power argues that the company supports the low-carbon transition in UK and ensures that the public and employees of the company are safe. Innovation and technology is a major step of UKPN to develop low-cost approaches in the transition to low-carbon economy. One way of benefiting the society as a means of corporate social responsibility and sustainable development is ensuring that the society is safe (Kolk and Tulder, 2010). Distributing electricity to households and businesses should be enhanced successfully without compromising the safety of the society. UK Power Networks aims at zero harm to the society and creation of public safety awareness. This shows that the company is committed to the interest of the society because the society obviously needs safety in all its operations including use of electricity. Conclusion The market structure of UK electricity distribution industry is an oligopoly which includes six large Distribution Network Organisations operating in different regions of the country and other small Independent Distribution Network Organisations with very small market shares. The eight-year price control and liberalisation of the electricity distribution industry in UK shows an increased entry of firms in future, and competition may rise. Existing firms prevent this entry through differentiation, large investments, and high technology. Electricity distribution industry in the UK contributes to the economy by increasing income and economic through salaried employment and high profitability which cause large investments in the economy. It also leads to access of electricity by homes and businesses for carrying out important activities that require energy. Lastly, the sustainability targets of the UK Power Network in its business plan reflects a true focus on the triple bottom line because it is concerned with the impact of the company’s operations on the environment, the society and profitability. References List Abdulrazak, S.R. and Ahmad, F.S. (2014). Sustainable development: A Malaysian perspective. Social and Behavioral Sciences, 164, 237-241 Ferrer, C.E. (2013). Oligopsony-Oligopoly: The perfect imperfect competition. Economics and Finance, 5, 269 – 278 Government of UK (2015). Policy: Maintaining UK energy security. Accessed March 19, 2015 from https://www.gov.uk/government/policies/maintaining-uk-energy-security--2/supporting-pages/future-electricity-networks IBISWorld (2014). Electricity Distribution in the UK: Market Research Report. Accessed May 18, 2015 from http://www.ibisworld.co.uk/market-research/electricity-distribution.html. Karagülle, A.O. (2012). Green business for sustainable development and competitiveness: an overview of Turkish logistics industry. Social and Behavioral Sciences, 41, 456 – 460 Kolk, A. and Tulder, R.V. (2010). International business, corporate social responsibility and sustainable development. International Business Review, 19, 119–125 Market Research Reports (2014). Electricity Supply and Distribution (Industrial Report) - UK - June 2014. http://www.marketresearchreports.biz/analysis-details/electricity-supply-and-distribution-industrial-report-uk-june-2014. My World of Work (2015). Electricity Distribution Worker. Accessed March 19, 2015 from http://www.myworldofwork.co.uk/node/20198. Scottish and Southern Energy Power Distribution (2014). About electricity distribution networks: now and in the future. Spence, A.M. (1977). Entry, Capacity, Investment and Oligopolistic Pricing. The Bell Journal of Economics, 8(2), 534-544. Sriram, K., Ganesh, L.S. and Madhumathi, R. (2013). Inferring principles for sustainable development of business through analogies from ecological systems. IIMB Management Review, 25, 36-48 The Telegraph (2008). Ofgem backs firms over price-fixing. The Telegraph, Accessed March 18, 2015 from http://www.telegraph.co.uk/finance/newsbysector/energy/2782758/Ofgem-backs-firms-over-price-fixing.html. UK Power Networks (2013). Business plan for our electricity network for East of England. London: UK Power Networks. UK Power Networks (2015). Our Business Plan for 2015-2023. Accessed March 19, 2015 from http://www.ukpowernetworks.co.uk/internet/en/about-us/business-plan/. Appendices Appendix 1: UK Electricity Distributors by Region (Gov.UK, 2015) Appendix 2: Business plans of UK Power Network (2013) Read More