Why Governments Regulate Energy Industry in the UK - Case Study Example

The Energy Sector Has the consumer been a beneficiary from the deregulation of the energy sector or has an oligopoly emerged that has failed them? Name of Student: Student no: Date: Name of Supervisor: Introduction The current economic crisis has affected the Western world in fundamental ways; there is stagnation in the US economy and the Euro zone is experiencing one crisis after another. It is quite possible that the UK will fall back into recession. The current economic downturn is not just a crisis but a paradigm shift in value that was precipitated by unwarranted fiscal speculation and encouraged by the imprudent political decisions of the last twenty years. Many of the current problems have been blamed on capitalism (Norman, 2011). This matter concerns the public in fundamental ways. For about thirty years, the British economy has been open, since the Thatcher government decided to float sterling, do away with subsidies from the state, dismantle cartels and enable privatisation of many industries including the energy sector and facilitate deregulation of London City. In order to gauge the acceptability of a system of regulation it is necessary to define the yardsticks by which it will be judged. Three potential elements exist in any new system of energy network regulation according to Pollitt (2008). In the first place, the role of the regulator within the process may undergo a paradigm shift in the future to an emphasis on ‘constructive engagement’ as well as ‘negotiated settlements’ between consumers and purveyors of network services. This would result in a change in the decision making process where the role of the regulator in investment selection is reduced and a greater inclusion of all parties involved in the decision on which investments to make. A further consideration to be made is minimisation of the monopoly right of the incumbent by facilitating generation of competition through competitive tendering. Elements within the network need to be examined for their potential contestability or competitiveness and these must be excluded from the monopoly price controls. Thirdly, the impact of climate change must be taken into account in line with the government’s green house gas emission reduction targets. This essay will seek to examine the effects of deregulation of the energy sector from the point of view of the consumer in an attempt to gauge whether the consumer has derided any benefit from it. This essay will also seek to discover whether there is an oligopoly that is taking advantage of the consumer and what can be done to minimise this. The British Model Competition was introduced in the British electricity industry in 1990, and the resultant reforms were known as ‘privatisation’ although other jurisdictions refer to the same phenomenon as liberalisation or deregulation. This ‘British Model’ was looked at as a success and many other economies attempted to duplicate it. This perception of success was mainly fuelled by the significant decrease in electricity price that occurred without compromise of quality of service. There seems to be a widespread presumption that the services provided by private entities was of better quality than those offered by their public counterparts. The European Union seems to have taken this to heart and justify the facilitation of competition for supply of electricity under the premise that it is a basic right rather than that it promotes better service delivery (Thomas, 2005). This judgement is political rather than practical and finds no justification in fact. It is not anywhere documented that the public hold choice of electricity supplier as a fundamental freedom. The public must take the more practical preference where both price and service are at premium. After the reforms in 1990, there was the expectation that retail competition would be introduced in three phases. The first phase to be implemented in 1990 would encompass those large consumers with a demand peaking at 1MW. This was to be followed in 1994 by medium consumers whose needs did not exceed 100kW and then spreading out generally to all consumers by 1998. In 1990, the effect of these changes on the small consumer was not imagined, with the assumption on examination of the cost structure, that competition amongst retailers would be minimal. Standard monopoly charges that are distribution and transmission at around 30% and generation 65% governed the electricity price for most small consumers. Because retailers were assumed to have bought the power at Pool or Pool-related prices, the prospect of one retailer getter cheaper power than another was dim (Thomas 2006). The small consumer spent only about 5% of their bills on retailers’ costs while large and medium consumers spent between 1-2%. This represented a notable saving for the latter two but not so for the former. Providing room for competition among medium and large consumers did come with some practical issues according to MacLaine (1999) which were not insurmountable and consumers adapted by switching suppliers or re-evaluating terms on a yearly basis, resulting in noteworthy price decreases. The outlay involved in introducing competition for these consumers pale into insignificance compared to the potential gains. It therefore becomes probable that the larger and medium consumers will be motivated and use their capacity to take advantage of the open market to minimise costs. The rub comes in when analysing cost distribution between different cohorts of consumers and whether this introduction of competition is cost effective and practical for the small consumer. The British energy regulator known as Ofgem obliged energy retailers to adhere to a non-discrimination requirement in September, 2009. This prevents them from having different mark-ups in various regions. The objective of imposing this requirement was to shield a section of consumers from the competition in the market. This requirement was to have a half-life of three years before it became subject to review. This change in policy was precipitated by the price differences observed in fourteen original regional electricity markets by a particular firm (Hviid & Price, 2010). Stole (2007) and Armstrong (2008) summarise the situation on price discrimination when the market is an oligopoly. One of their strongest findings was that the ban on price discrimination is likely to lead to an increase in overall prices in the market. Where the tableau is broken down to its simplest form, when costs are uniform across the board in regional markets, a requirement for non-discrimination is reduced simply to a most-favoured-customer guarantee. When this scenario is applied to the end user, the result is increased prices and decreased care (Hviid and Shaffer (2010). The power market in the UK consists of distinct regional submarkets each of which has two incumbents and four competitors. These are further broken down into one incumbent present in all submarkets and the other, in a lesser number of submarkets, while competing in the rest. The competitors in one market are all incumbents in other markets. The market is defined as having a robust brand loyalty for the incumbent because 70% of consumers seem to have a tendency to source their power from the local incumbent. Furthermore, because of the need to attract consumers from the incumbent in other markets where they compete, whatever profit is generated from extra-regional sales is much less than that generated within the incumbency area (Hviid & Price, 2010). Information is disseminated by Competition Authorities in order to facilitate active searches by consumers in order to find the best deals that would afford them the greatest advantage (Garrod et al, 2008). There is evidence according to Rotemberg (2008) that most consumers have limited expertise or awareness of prices, are regularly driven by disappointment in their own decisions and ire at the seeming inequality in market opportunities. As a result, they find it hard to select the best choice from a variety of price choices. There are several researches that prove that consumers have a tendency not to select the most advantageous options for themselves when given a choice of tariffs, whether it is provided by one or competing suppliers. Examples of such researches are the Economides et al (2006) and Wilson et al (2007) who studied UK electricity consumers. Researches done on energy usage in the UK predominantly return results in which evaluating consumer choices find that the motivation for switching suppliers is usually the perceived advantages. The most influential factor in the consumer’s choice to switch suppliers is a factor of switching cost proxies according to Giulietti et al (2005) who surveyed seven hundred UK gas market consumers. In 1998, the fact that the small consumer was a casualty of price reductions to large consumers became clear. Information published by the regulator showed that the retail power brokers were distributing the cost of their costly wholesale acquisitions to the captive market while their less expensive ones were allocated to the competitive market. The former consisted of coal generation and dash-for-gas factories constructed by the RECs, while the latter consisted of nuclear plants and imports. The subsidies allocated to nuclear power between 1990-1996 which amounted to six billion pounds sterling and the writing off after privatisation of monies spent by consumers on construction after privatisation in 1996, made that power cheap. Expensive power on the other hand, put the regulator in a difficult position because he was tasked with ensuring that there was no discrimination with regard to consumers yet the coal contracts that were mid-wifed by the governments guaranteed that this power could be allocated to small consumers. This made it difficult for the regulator to prevent discrimination in this way. In 1992, the regulator inspected REC plants and certified that they met the criterion for purchasing power economically. It was therefore difficult for the regulator to go back on this position and so his standing with these plants was already compromised (Thomas, 2006). The result of the compartmentalisation of contracts was that the small consumer ended up paying 30% more for bill generation than did larger consumers. If generation costs had been evened out amongst all consumers, the small consumers would have experienced a price reduction of 7.5% (Thomas, 2006). The Energy Select Committee of Parliament required that the Regulator produce a cost to benefit analysis of retail competition for this group of consumers (House of Commons Trade and Industry Committee, 1998). The results showed that the main objective of the benefits was that passing on costly power outlays to consumers would not be possible due to competition. The fact was that coal contracts, which were considered to be the ‘expensive’ power were concluding in 1998, the same time that introduction of retail competition was expected to commence. Thus the premise that the latter was responsible for the end of the former is unwarranted. However, the final cost to benefit analysis, although doubted by many commentators such as Green and McDaniel (1998) implied that there would be an even charge across the board for power generation and any costly purchases by generators would have to be offset against their profit. However a report by the NAO indicates that this is not the case on the ground. Expensive power acquisitions are still being passed on to the small consumer by retailers. This has been exacerbated by deregulation; at the time when supply was a monopoly, retailers were obliged to mark up their prices strictly by the same amount paid for generation however after deregulation, they are free to determine their own profit margins (National Audit Office, 2003) The cost of transmission and distribution may be pre-determined but the retailers are allowed to choose their retail margins to as much as can be borne by the market. This is illustrated by the report by Power UK20 which showed that while the wholesale price of power dropped by 35% between January 1999 and January 2002, when broken down into consumer segments the results showed that large consumers paid 22% less for their generation and retail elements while small consumers had a bill increase of 5%. Under the latter category, it has been proven that retailers aim for the more well to do consumers from whom profit share would be larger and to whom it would be increasingly possible to sell other products from the electricity retailer (Jewell, 2003). There is also discrimination via mode of payment with those who pay by direct debit of preset amounts debited directly from their accounts being afforded the lowest rates while prepaid consumers who comprise 15% of consumers, pay the highest rates. It is assumed that consumers will respond to information by becoming more proactive in their power purchase decisions. This assumption is based on the utility maximisation theory for its success, but the growing evidence on the ground and new aspects of economic theory suggest that consumer behaviour is not that straightforward. The provision of information to consumers becomes counterproductive when the reaction to that information goes against predictions as laid out in the model. In fact, adverse effects may result and the situation could become much worse than before the solution was mooted. This is illustrated by Silk (2006) when he gives the example of what could occur should consumers be given time to explore their options with the assumption that should they make an erroneous purchase, they could go back and undo that decision. In reality, should they not do this, the power companies gain more market. In a similar way, should the decreased search and switching costs not be countered by increased activity, the resultant boost in market confidence will culminate in greater market power for firms (Waterson, 2003). The outcome of this is that because these solutions are expensive to execute, the prices are likely to go up as a result. On the other hand, should consumers choose to act according to the assertions of the conventional model of utility maximisation they become significant tools of support for market efficiency. When consumers take the initiative to shop around for the best deal, that is most commensurate with their needs, then they are motivators for effective competition. When they do not exercise this option, the result could be market power for firms that can be socially damaging. Consumers fail to exercise their options either because they fail to conform to the utility maximisation model, or because they are ignorant of the prospect of choice between competing suppliers. Other reasons are the complexities involved in identifying the product-price offerings or due to high switching costs (Chang and Price, 2008). It is important for policy makers to comprehend the ability of consumers in order to optimise policy response. This response is very distinctive in different situations. The improvement of access to consumer information in terms of search costs reduction and increased awareness varies from other means of reducing switching costs such as enabling the opening and closing of bank accounts and facilitation of quick and easy change of direct debit. In addition policy may have to be formulated that targets certain consumer categories that may be getting the short end of the stick as has been seen with small consumers. Furthermore, it may be discovered that some issues are only pertinent in specific markets and the demographic breakdown may be useful. Conclusion The reasons why governments regulate industry may vary from lobbying from those who stand to economically benefit, to the best interests of the regulated industry, even with an eye to re-election. These motives differ from the technical justifications that are used to regulate industry. However, what it all boils down to is market failure; that is, the market has failed to conduct itself in such a manner as to be in the public’s ‘best interest’. It has somehow gone out of control and is in need of outside help (Baldwin et al, 2012). When the privatisation of electricity in the United Kingdom is critically analysed, it is difficult to see why they have such a high reputation. While favourable results have been recorded to date, these seem to rely on three factors; the good luck to enjoy a beneficial fossil fuel market; a critical advancement in nuclear power plant performance; as well as a the fact that the industry was privatised at about half its prior financial value which means that there was resource transfer from tax-payers to electricity consumers. When estimating the success or failure of reforms, the decisive factor should be whether efficiency in the market has improved. This cannot be said to have occurred in the UK, with the wholesale market’s uncompetitive nature persisting. This is exacerbated by confidential long-standing agreements, self-dealing amongst purveyors and restricted access to the market overshadowing the market and resulting in negligible liquidity and unreliable rates. Since there is no reliable, trustworthy wholesale electricity industry, the obligation moves to the retailers to impose competition on power suppliers. This undertaking can be done by large consumers who are beneficiaries of liberalisation. These benefits have been obtained at the expense of the small consumer, with the poorest being the most disadvantaged. The government must therefore reinforce the regulator to prevent the exacerbation of this exploitation. This should be done with expedience because forecasts for the future are currently not so bright. The rise in the price of fossil fuel prices as of 2002 followed by the 15% rise of retail prices to small consumers between January 2003 to March 2005 was the first harbinger of things to come. The electricity industry is close to an oligopoly with token competition only with the resultant implications. Consumers are increasingly required to foot the bill for replacement of pre-privatisation equipment that may have been written off, at full price. The reasons for regulation are many and varied and in any industry these reasons may be singular or myriad. These reasons could include market failure, but also human rights and social solidarity. The health and safety of consumers must also be factored in. All of these factors do apply in the case of power regulation. The issue remains that regulation does not seem to have gone far enough to ensure consumers’ rights. References Armstrong, M. (2008). “Price Discrimination”, in P. Buccirossi (Ed.), Handbook of Antitrust Economics, MIT Press. Baldwin, R., Cave, M. and Lodge, M. (2012). Understanding Regulation 2nd Ed. Oxford University Press. UK. Chang, T.Y. & Price, C.W. (2008). Gain or Pain: Does Consumer Activity Reflect Utility Maximisation? CCP Working Paper 08-15 Economides N., Seim K. and Viard V.B. (2006). “Quantifying the Benefits of Entry into Local Phone Service” NET Institute Working Paper #05-08,August. Garrod, L., Hviid, M., Loomes, G., Waddams Price, C. (2008). Assessing the effectiveness of potential remedies in consumer markets, Office of Fair Trading (forthcoming). Giulietti, M., Waddams Price, C. and Waterson M. (2005). “Consumer Choice and Competition Policy: A Study of UK Energy Markets.” Economic Journal, 115(506), pp.949-968. Green, R., McDaniel, T. (1998). Competition in Electricity Supply: Will ‘‘1998’’ be Worth it. PWP-057. University of California Energy Institute. House of Commons Trade and Industry Committee. (1998). Developments in the Liberalisation of the Domestic Electricity Market. 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