OFGEM Findings Discussion - Example

OFGEM Findings Discussion Analysis of the UK Energy Market Introduction The United Kingdom (UK) energy sector is one of the essential driving forces of the country’s open economy. The major players in this market, according the country’s Office of Gas and Electricity Markets (OFGEM) report of March 2014 are; SSE, Scottish Power, Centrica, RWE Npower, E.On, and EDF Energy. These firms account for at least 95 percent of the energy market and are informally referred to as the ‘Big Six’. This essay intends to analyse the structure of energy market of the UK with the aim of establishing the nature of the relationship between the big six firms, and how such a relationship impacts on the energy prices. In addition, the paper seeks to establish if there are government controls to regulate the energy market. The significance of government controls is to cushion final consumers, as well as guard the interests of the producers and distributors. This paper will examine the effectiveness of such controls if there exists any. To achieve these objectives, this paper borrows heavily from the findings of the OFGM report (2014), among many other reports that have done previous studies on the UK energy sector. Analysis of UK Energy Sector An analysis of figure 1, about energy prices in the UK for the years 2011 to 2013, shows one general observable trend. The domestic prices of both Electricity and gas keep rising steadily over the years. The chart also shows that the prices of gas at any given time are higher than the prices of electricity. For example, for the year 2011, the average price of electricity is 5 Euros, while that of gas is approximately 8 Euros. For the year 2012, the average price of electricity is 9 Euros, while that of gas is approximately 16 Euros. It is, therefore, proper to conclude that the two, gas and electricity, have a positive relationship. Ideally, natural gas and electricity are close substitutes, whereby a rise in the price of either commodity leads to a rise in the demand of the other commodity, and vice versa (Rudolf, 2012). From figure 2 about the Herfindahl-Hirschman index on UK energy market for the years 2011 to 2013, it is observed that there was a rise in the index between 2011 and 2012. For the period between 2012 and 2013, the index became relatively stagnant. This implies that the period between 2011 and 2012 saw a significant number of firms withdraw from the market. A high concentration of firms in a monopolistic competitive market implies that firms will have to share the profits. The number of consumers remains constant and firms have no power to alter it. As a result, the average profit for every firm reduces, discouraging some firms who eventually withdraw from the market (Swati & John, 2012, p.14). Therefore, the author concludes that the period between 2012 and 2013 experienced a stagnant Herfindahl-Hirschman index, because a number of firms had already withdrawn from the market. The few firms that remained had no further incentive to withdraw because profits had stabilized already. Figure 3 represents the portion of disposable income spent by poor and rich households of UK on energy between the years 2002 and 2012. Over this period, expenditure by the rich on household energy rose from 2 percent to 3 percent. Similarly, expenditure by the poor rose from 8 percent to 12 percent. This shows that energy requirements are basic for every household; otherwise, the poor would not have spent a whole 11 percent on it. The disparity of the proportion of income spent by the rich and the poor is due to the income gap between the two classes. The rich are able to designate a huge amount of their income for expenditure purposes unlike the poor. Profitability by UK’s major energy firms between the years 2009 and 2011 rose by 556 Million Euros. Of this, 97 Million Euros represented generation capacity by the firms. Generation of profits can be attributed to a good taxation regime and low inflation rates during the same period. The period between 2011 and 2013 saw profits generated by the major firms drop by 861 Million Euros. This is majorly attributed to the economic meltdown in the Euro Zone. Besides gas and electricity, there are other forms of energy used in UK, namely; coal, oil, paraffin, and wood. Gas and electricity account for at least 40 percent of total monthly expenditure by households on energy (Table 1). In terms of firm representation in the market, Centrica controls the largest market share of 30 percent. Only 9 percent of the UK energy market is controlled by firms outside the ‘Big Six’ (Figure 6). Theoretical Conceptualization of the UK Energy Market Part A Energy production involves four key stages, namely; generation, transmission, distribution and supply (Richard, 2006). The UK energy market structure is multi-dimensional, but it is best suited by a monopolistic competitive type. A monopolistic competitive market has a number of characteristics, including; presence of many firms, similar products or close substitutes, easy entry and exit by firms, and firms do not necessarily counter actions by one of them since they are many. Various measures have been undertaken by the UK government towards enhancing competitiveness in its energy sector. One of the measures adopted by the UK government was to liberalize its energy sector. Initially, the Central Electricity Board and the National Grid were responsible for energy production and distribution (Richard, 2006). Liberalization of energy production has been done sequentially by various government regimes. The first acts to privatise the energy sector began in 1980s, and have been ongoing since then (Richard, 2006). For example, the National Grid Company was listed in the stock exchange in 1997. As per 2006, only a small proportion of the company was still being held by the local governments. As a consequence of privatising the energy sector, a number of many other companies came up with their own power plants to add up to the national grid. As noted by the OFGEM report of 2014, apart from the ‘Big Six’ companies, there are many other micro-companies engaged in energy production. Due to the presence of many suppliers, consumers have the advantage of being presented with diverse options of companies from which to source their energy. Rationality in consumers dictates them to choose a product that offers them maximum utility, while being affordable as well. For this reason, individual companies have to fight to win customers so as to make more profits. In monopolistic competition, companies fight competition using various methods. Some of the methods include; product differentiation, mark-ups, advertisements and after-sale services. Firms have to ensure that the costs incurred in the process of producing any extra unit, also referred to as Marginal Cost (MC), do not exceed the revenue derived from sale of one such unit or the Marginal Revenue (MR). In monopolistic competition, the market equilibrium is attained where MC=MR. From the diagram below, the point of intersection of the MC and the MR line is the equilibrium price and quantity. At this point, firms neither make profits or losses. To maximise on profits, firms increase the price charge where the equilibrium quantity intersects with the demand curve. The demand curve is higher than the marginal revenue curve, hence profit will be generated. Part B After OFGM conducted its research, it found that the UK energy market was not performing the way it should be. The advantages of competition did not seem to be fully realized. As a result, OFGEM proposed four measures which would bring reforms to the UK energy market. They include; Retail Market Review (RMR), liquidity review, greater consumer engagement, and vertical integration. A survey by OFGEM’s retail monitoring unit found that the market was not functioning properly. The report proposes that tariffs be simplified to be more understandable to consumers. RMR also proposed that there be proper provision of information regarding all products in the market in order to enable consumers make informed choices. The RMR exercise further proposed the enactment laws that will instil discipline in the market. Lastly, RMR proposed provision of crucial information to businesses regarding their operations. Such information includes expiration of contracts. The second reform proposal by OFGEM is liquidity reform. OFGEM proposed that small businesses be empowered to join the market through adequate financing. The major goals of liquidity reforms by RFM include; efficient short-period markets, hedging, and good stable prices. OFGEM also discovered that consumer participation in running of the market environment was very dismal. For this reason, in their report they suggested that consumers need to become adventurous in choosing who to buy from. The report notes that by juggling suppliers, consumers increase their chances of making savings by accessing cheaper prices. Vertical integration means empowering new firms to achieve the status of the ‘Big Six firms’. Only the ‘Big six ‘of UK oil producers can independently sustain their domestic requirements. More financial aid needs to be given to uprising firms to be able to compete fairly. Conclusion Having analyzed the findings of the OFGEM, as well as studied various academic sources, the author concludes that the findings by the FGEM are generally true. It is true that the UK energy market is dominated by the ‘Big six’ companies who control an estimated 90 percent of the market. Furthermore, the assertion that the big firms collude to affect prices of energy products is also verifiable. The firms have the freedom to alter prices, but they decide to hold the prices at a particular level instead. It means the firms are carefully operating in a manner that suggests they are in constant communication. The effect of this is that the structure of the market deviates from being monopolistic, and instead develops to an oligopoly. As a result smaller firms have found it hard to join the market. The government needs to intervene and cushion the consumers by imposing price limits. Consumers, on the other hand, need to be more vigilant and watch their expenditure on energy more keenly. For example, it is advisable that energy spent on lighting through electricity during daytime can be avoided by using natural lighting. Therefore, the OFGEM findings, as well as their resolutions are true. Works Cited Dhingra, S. & Morrow, J., 2014. Monopolistic Competition and Optimum Product Diversity Under Firm Heterogeneity. London: s.n. Harford, T., 2008. Perfect Competition, Monopoly, and Monopolistic Competition, s.l.: s.n. OFGEM, 2014. Making a positive Difference, London: OFGEM. Pond, R., 2006. Liberalisation, privatisation and regulation. London: Working Lives Research Institute. Winter-Ebmer, R. & Linz, J. K., 2012. Managerial Economics. s.l.:W. W. Norton & Company. Read More