Competition in the UK Energy Market - Case Study Example

Competition in the UK energy market Introduction The competition in the UK energy market is deemed to be low, despite the fact that there are several operators who serve as the energy suppliers to the consumers in this market. It is this low level of competition among the suppliers operating in the energy sector in the UK that has raised concern over the possibility of the consumers being exploited. According to the Office of Gas and Electricity Markets (Ofgem), there is suspicion that the firms operating in the UK energy market have coordinated their business in a manner that hinders any meaningful competition (OFGEM, 2014:5). However, no evidence of collusion between these firms has been found that far. Thus, the objective of this essay is to establish the nature of competition in the UK energy sector, and thus determine whether the attributes of the market can be categorized under perfect competition, oligopoly or monopoly. To establish which market structure suits the UK energy market, the nature of the relationships between the energy consumers and the suppliers will be evaluated, while the relationship between the suppliers, the possible profit margins and the nature of barriers to entry into the UK energy market will be assessed. The essay will conclude whether it is necessary to increase competition between the suppliers in the UK energy market to foster more consumer benefits. Analysis of the UK Energy Sector The graph of Domestic Energy Prices 2011-2013 in Figure 1 of the appendix portrays a constant increase in both the prices of gas and electricity in the UK energy market by 25% for gas and 15% for electricity within the three year period. This is an indication of lack of adequate competition in the energy markets. This is due to the fact that; perfect competition in the market results in the decline of the prices of commodities, as the players in the markets seek to increase their sales by lowering the prices of their commodities (Perloff, 2008:445). Additionally, the graph in Figure 2 of the appendix showing the market concentration in the UK Energy Firm Market for the period 2011-2013 indicates that the market concentration has increased exponentially between 2011 and 2013. This is an indication that there could be a possible coordination between the firms to stifle healthy and free competition in the market (Tirole, 1988:27). Further, the fact that the prices of both gas and electricity in the UK energy market have been increasing exponentially over the three year period between 2011 and 2013, while the market concentration in the sector for the same period has continued to increase, shows that the interaction among the firms operating in the market lacks any meaningful competitiveness (Great Britain, 2011:156). The Herfindahl-Hirschman Index measures the possible number of firms that operatewithin market for a given period of time. According to Figure 2 in the index, Herfindahl-Hirschman Index for the UK energy market for the period 2005-2011 was low at 1050, an indication that there were many firms that were operating in the market. However, the index increased for the three-year period between 2011 and 2013 to almost 1400, an indication that only few firms were operating in the market. In addition, the suppliers’ market share in the UK energy market by 2014 indicates that the whole market is only dominated by 6 firms, according to Figure 6 of the appendix. This is a clear indication of lack of healthy competition in the market starting 2011 through to 2014. The spending of the disposable incomes for the UK households for the period 2002-2012 as shown in Figure 3 of the appendix indicates that the poor households increased their spending on energy from 8% in 2002 to 11% in 2012. On the other hand, the same figure indicates that the rich households only increased their disposable income spending on energy slightly, from 2% in 2002 to 3% in 2012. This is a clear indication of a possible exploitation of the poor by the firms operating in the UK energy sector, further underlining the fact that healthy competition in this market is lacking. Application of Economic Theory a. Market structure that best describes the UK energy industry The UK energy sector operates on the basis of forces of demand and supply, where the suppliers provide the energy requirements of the consumers based on the consumers demand for both gas and electricity. The supplier firms can work in any one or all of the energy sector supply chain activities which entails the generation of electricity, transportation of gas and electricity, and selling it to the consumers (Great Britain, 2011:156). The general theory of markets defines market structure as the number of firms that are producing homogenous and identical products within a market (Tirole, 1988:47). In this respect, the number of firms that operate and control the market share serves as the basis on which a market structure is defined. The UK energy market operate under a market structure where the “utilities often favor more traditional supply-side options” (Warren, 2014:945). This simply means that the consumers will always opt to purchase both gas and electricity from the most traditional suppliers within the UK energy market, as opposed to going for the new entrants into the market. This observation has also been supported by the Ofgem report findings, which concluded that in the UK energy market, incumbency advantage plays an important role in favoring the six major firms that operate in the sector. The findings of the Ofgem report conclude that in the UK energy market, there are a large percentage of consumers who never or rarely engage with the new markets, rather sticking with the incumbent energy suppliers for the provision of their gas and electricity requirements (OFGEM, 2014:5). The UK energy sector is also characterized by overdependence on the fossil fuel power generation, such that there is little power generation from other alternatives such as the green energy alternatives. This being the case, the production of energy in the UK from the non-fossil fuel micro-generation alternatives comprises of only 7% of the total power supply in the country, while 93% of the power supply is through low-voltage distribution networks, which operate under a highly centralized system (Allen, Hammond & McManus, 2008:530). Accordingly, the UK energy market can be categorized as an oligopoly market structure. This is because, oligopoly is a market structure that is characterized by few but large firms dominating the market (Perloff, 2008:447). Under an oligopolistic market structure, the firms operating can decide the prices they will charge for their products, which is much higher than the equilibrium price. Figure 1: A graph of Oligopolistic market structure Figure 1 shows the price; (the triangular region above P), under an oligopolistic market structure, where the price has been set much higher than the point of intersection of the demand and output. This enables the firms to benefit from charging their customers a much higher price, since the level of competition among the firms is low. This is contrary to a monopolistic market structure where only one firm dominates the market, and also contrary to a perfect competition market structure, where there are many sellers operating in the market, such that no single firm can dominate the market. Under perfect competition, there is a high price competition, such that the price is determined by the intersection of the demand and supply, as opposed to other factors. Figure 2: A graph of perfect completion Figure 2 demonstrates that the price, P, under a perfect competition market is determined by the intersection of the quantity demanded and the quantity supplied in the market. This creates healthy completion that favors the consumers. b. Proposed reforms to make the UK energy market more beneficial to UK consumers Increasing liquidity in the UK energy market is a reform that has been proposed by Ofgem. This measure will ensure that independent suppliers can be able to access wholesale products, and thus offer the energy products to the consumers at lower prices (OFGEM, 2014:7). The other proposed reform is a move to a European-wide market. This will increase the number of players in the energy sector, which will effectively increase completion (OFGEM, 2014:9). The Retail Market Review is yet another proposed reform, which will entail the simplification of tariffs applicable in the energy sector. This will work towards incentivizing more operators to join the market, and thus boost competition (OFGEM, 2014:27). Finally, smart metering has been proposed as a reform that will enhance competition in the UK energy market, through attracting new suppliers to offer the meters, and also through breaking the confidence barrier that exists in the customers towards new suppliers, since the customers will now be able to monitor and control their electricity consumption (29). Conclusion The UK energy sector lacks adequate competition to effectively create a fair market where the consumers cannot be exploited. The dominance of the six traditional suppliers in the UK energy market has created an oligopolistic market structure, such that the firms are able to discriminately charge high prices for the supply of both gas and electricity to the consumers. Consequently, there is a need for the implementation of measures that can increase the level of competition in the market. Such proposed measures include the review of the energy retail market through introducing regulations that entrench fairness among all the suppliers in the market. The other proposed measure is the introduction of liquidity reforms in the sector, which will enable independent suppliers to easily join the market and thus boost competition, which will in turn drive the prices of gas and electricity down. Considering the fact that by 2014 the six major suppliers in the UK energy sector held the largest share of the energy market, it is simply agreeable that the firms operate as oligopolies, which is detrimental to the consumers. Bibliography Allen, S., Hammond, G., and McManus, (2008), ‘Prospects for and barriers to domestic micro-generation: A United Kingdom Perspective,’ Applied Energy, 85, pp. 528-544 Great Britain. (2011), ‘UK energy supply: Security or independence? : eighth report of session 2010-12,’ London: TSO, 156-158. OFGEM (2014), ‘Consultation on a proposal to make a market investigation reference in respect of the supply and acquisition of energy in Britain,’ 1-43. Available at: https://www.ofgem.gov.uk/ofgem-publications/86807/consultationpublish.pdf Perloff, J. (2008), ‘Microeconomics Theory & Applications with Calculus,’ Pearson Education, 445-447. Tirole, J. (1988), ‘The Theory of Industrial Organization. Cambridge,’ Mass.: MIT Press. 7-55. Warren, P. (2014), ‘A Review of Demand-Side Management Policy in the UK,’ Renewable and Sustainable Energy Reviews, 29, pp.941-951. Read More