Basic Papers

The Future of Electricity Markets:

Real Working Market Economy or Becoming Oligarchy?

Steve Thomas^*

 

I will divide my presentation into three parts. In the first, I will discuss the British model and demonstrate that it is not working as smoothly as it is often portrayed as doing, and even a decade after the reforms, the structure and mechanisms are still evolving rapidly and unpredictably. In the second, I will examine the rest of Europe and show that, outside the Nordic region and the Netherlands, little has changed yet, although radical change is probably inevitable. There are signs that governments are allowing the emergence of a 'national champion' electric utility to protect them from the loss of control liberalisation might bring. In the third, I will examine how companies will view the electric sector in the future, identifying a risk that the sector will become dominated by a handful of international giants. This is likely to be to the detriment of consumers and of national sovereignty.

Experience in Britain

The privatisation of the British electricity supply industry was inevitably a chaotic and confused process. It was the first time any country had attempted to reform their electricity supply industry to run on competitive lines. However, it was also a highly political process, run to a very tight timetable and with powerful interest groups that had to be satisfied. The opposition Labour Party threatened to reverse the process if they were re-elected so the whole job had to be done in about three years to make things irreversible. The coal-mining industry and the nuclear power industry both had considerable political power and required special arrangements, and the views of the electricity supply industry itself had to be taken account of. The ideal structure being sought had to be severely compromised to take account of these factors.

Beyond some vague notion that competition was being introduced, most people, including some specialists had little idea of what was going on, other than that shares in the new companies would be on sale and easy profits likely to be available. The concepts are now much more familiar and, with hindsight, it is reasonably clear what was being attempted: privatisation, restructuring (de-integration), introduction of competition and re-regulation. It is interesting in examining what was done in Britain to compare it with the parallel process in Norway.

The new system went live on April 1 1990, but much of this agenda could not be completed then. The period since then has seen a complex process involving the government and the Regulator trying to fulfill their design ideal, reactions to unexpected events and the electricity industry's attempts to shape the industry to meet its own agenda.

Privatisation.

It must be remembered that the primary motive for the reforms, as with the rest of the privatisation programme, was to transfer ownership from central government to private share-holders. Mrs Thatcher's rhetoric concentrated far more on the evils of public ownership than on the virtues of competitive markets. That is why the national gas and telecommunications monopolies were privatised intact. It was only the growing public dislike of privately owned monopolies that led to attempts to introduce competition. A feature of the overall British privatisation programme was that a large proportion of the shares was sold to the general public and, if the policy was to be popular, this meant the shares had to be under-priced and the risk of failure of the new companies minimal. Privatisation was no part of the agenda in Norway. Rationalisation gave the initial impetus there, but, influenced by Britain, introducing competition became the driving force.

For various reasons, especially the distortion to the Stock Market that would have resulted from a channelling of so much money into a new activity, the companies could not all be sold immediately. The 12 distribution and retail companies, previously known as Area Boards, were renamed Regional Electricity Companies (RECs) and were privatised over the first year. The two large generators (National Power and PowerGen) drawn from the Central Electricity Generating Board (CEGB) were sold in two parts, in 1991 and 1994. The nuclear sector (also previously part of the CEGB) was not privatised initially, the plants being placed in a new government-owned company, Nuclear Electric. However, in 1996, Nuclear Electric was combined with its Scottish counterpart, Scottish Nuclear, and re-divided into a larger company which was privatised then (British Energy) and a rump, nationally-owned company which cannot be privatised (Magnox Electric). The National Grid Company (NGC), previously part of the CEGB, was initially jointly owned by the RECs, but they were forced to sell their stakes in 1995.

Restructuring.

The architects of the new system saw vertical integration as an anti-competitive force, for example, because of the risk that monopoly businesses would be used to cross subsidise competitive activities. As a result, they tried to split the industry into four separate activities: generation and retail as competitive businesses with multiple actors, and transmission and distribution as monopoly activities. In Norway, while there were attempts to separate monopoly activities, creating a grid company and requiring an accounting separation of retail and distribution, generation and retail were allowed to remain integrated.

The highly concentrated old system, dominated by the CEGB, could not easily be de-integrated and split into the large number of companies the design implied. In part this was because some of the new businesses, such as transmission or retail, were too unfamiliar as stand-alone businesses for the City to place a proper value on them. There was also the logistical problem of creating a large number of new management teams. As a result, the Area Boards were privatised intact with some accounting separation between the distribution and retail parts of their businesses. It was planned that the CEGB would be split into only three parts, two generators, National Power which was to own the nuclear stations, PowerGen, and the grid company. The unwillingness of investors to buy the nuclear assets meant they had to be withdrawn from the sale and left in public hands in a fourth company.

Subsequently, the Regulator forced the RECs to sell their shares in NGC, although this was mainly to give NGC more commercial freedom rather than to prevent abuse of their position. He also required National Power and PowerGen to sell 6000MW of old plant in 1995 to reduce their market dominance. However, the buyer was a REC, Eastern, so market dominance was reduced at the expense of increased vertical integration. The Regulator is now pressing for further plant sales by National Power and PowerGen.

By 1997, the Regulator was becoming concerned that the RECs were able to cross-subsidise their retail business from their distribution business, choking off retail competition and he began to lobby for complete corporate separation of distribution and retail. It is not clear how far the government will require the further separation of distribution and retail to be taken. But as a minimum, it is likely companies will have to operate distribution and retail from separate premises with no overlap of staff or facilities.

Competition

Reflecting this de-integrated structure, competition in Britain was to be inserted in two places. A wholesale power pool was to be created through which all power had to be traded. Hedging contracts were allowed but the expectation was that the Pool price would be a dominant force, setting current wholesale prices and future contract terms. At the retail end, all consumers would be allowed to choose their retail supplier or buy direct from the Pool. In Norway, an existing Pool was extended, but remained a marginal trading instrument although it too was expected to be a price-setter. Like Britain, consumers in Norway were also to be allowed choice.

Generation competition. The special arrangements necessary to prevent the collapse of the coal (which then accounted for 70 per cent of generation) and nuclear (then 15 per cent of generation) sectors meant that these were effectively taken out of the generation market until 1998. Nuclear was given a consumer subsidy (10 per cent of all bills and about 50 per cent of Nuclear Electric's income) to run until 1998. The subsidy was limited in duration by the European Commission and there was no clear idea of what would happen at the end. The RECs were forced to buy all the output Nuclear Electric could produce. The nuclear share increased, through better plant performance, to about 25 per cent by 1998. Imports of power from Scotland and France and renewables, between them about 10 per cent of the market, were also able to claim the nuclear subsidy and were also effectively out of the market.

British Coal was protected by government enforced contracts selling coal at pre-determined prices to the generators which in turn sold all the output, again via government enforced contracts to the RECs, also prices outside the control of the RECs. The contracts initially ran for three years but were then extended following government intervention for a further five years with steadily diminishing volumes. In 1990, coal accounted for more than 70 per cent of the market, falling by 1998 to about 40 per cent.

The RECs, unhappy at the prospect of having to negotiate with what they saw as a duopoly when the first coal contracts ran out in 1993, and keen to expand their businesses into new sectors, took advantage of the rule that allowed them to buy about 20 per cent of their power needs from plants owned by themselves. About 5000MW of gas-fired combined cycle (CCGT) plant was ordered in the 18 months after privatisation. The RECs sold themselves the power on 15 year contracts for base-load power at terms unrelated to the Pool. From 1993 onwards, these plants began to come on stream and now account for about 20 per cent of the market.

If the contributions of nuclear, British coal, imports, renewables and RECs' own plants are added together, throughout the period from 1990 to 1998, more than 90 per cent of power generated was bought and sold at prices which had little or nothing to do with the Pool. Companies with contracts for power bid zero into the Pool for their contracted plants simply to ensure the plants were dispatched. They received the contract price whatever the Pool price (even if it was zero). The small amount of power that has been traded at Pool prices has been supplied almost exclusively by National Power and PowerGen, leading to fears from the Regulator that they would use this dominant market position unfairly. He is now pressing for them to sell more old coal-fired plant which can be seen as a 'price-setter' in the Pool and the two companies are both currently investigating the sale of a further 8000MW in addition to the 6000MW already sold.

The only power purchasing that the RECs have had some influence over was the plant they built for themselves. Ironically, this has proved to be a major loss-maker. The collapse in North Sea gas prices and the rapid improvement in CCGT technology means that for much of the year, the marginal cost of generation at these plants is higher than the Pool price. However, the gas contracts are take-or-pay so they cannot reduce the output from these plants.

As well as these structural problems, the Pool has also suffered because when the system was created in 1990, new software development had to be abandoned in order to stay within time-table. The Pool software is modified, ancient (CEGB) software which has been close to collapse on a number of occasions and its replacement is urgent.

Since the expiry of the coal contracts in April 1998 and the phasing out of the nuclear subsidy a year early in 1997, the generation market has been in a sort of limbo. The new Labour government has been investigating ways to save what remains of the British coal industry by encouraging coal burn in the power sector; the new arrangements to replace the Pool are under discussion; the introduction of competition to small consumers is slowly being carried through; and many of the owners of the RECs no longer seem to have much interest in the companies. Until these issues are resolved, RECs are not willing to commit themselves to a power purchasing strategy and, for the last year, electricity purchasing has gone on largely under a continuation of the terms that applied previously.

Nearly a decade after the system was reformed, the generating companies and the RECs still have very little experience in negotiating contracts for the purchase and sale of power.

The compulsory, market clearing Pool is now expected to be abandoned. It is likely to be replaced with looser arrangements based on a mixture of long-term contracts and confidential bilateral deals made in the period from 24 to 4 hours before the event (at which point the NGC will take over to balance the system). It is predicted that a range of trading instruments such futures markets and options would emerge. These arrangements are still being discussed and few would try to predict how they will work in practice. Those operating commodities markets will clearly welcome the opportunity to trade in a large new market and will have a strong self-interest in promoting the benefits of such a trading regime.

However, if as has been the case up to now, long-term contracts at rates not related to the market are still totally dominant, the nature of the market is irrelevant and the decision to abandon the Pool is not important. Nevertheless, it must be recognised that some important remaining objectives are being abandoned with the scrapping of the Pool. The Pool was expected to provide a marker price to give signals to market players. There is no provision for a marker price in the new arrangements. The Pool also appeared to lower barriers to entry for new generators. If a new company could beat the market price, it could enter the market and make a profit. In the new arrangements, there is no guarantee that a new entrant can enter the market if it does not have contracted customers - under the concept of 'contestable markets', the possibility of new entry may be sufficient to increase the competitiveness of a market.

The problem of making generation competitive may not be solvable simply by increasing pressure on generators to behave competitively and on fragmenting the sector further. If the generation market is really competitive, whatever form the market takes, owners of generation plant will not be able to predict much in advance how much power they will be able to sell and how much they can sell it for. If retail competition is effective, retailers will not want to sign long-term power purchase deals because they will not be able to predict their market share and they will not want to lock themselves into potentially expensive long-term deals. How will it be possible to finance new power station construction in such a situation?

Project finance will probably be impossible for small generators and only companies with strong market shares and preferably captive consumers will be able to justify building new plant. The key question is, is there a 'magic' number of generators of generators which is small enough to allow them to have a large enough 'portfolio' of plants to hedge the risk of building new capacity, but large enough to represent a real market?

Retail Competition. Unlike Norway where full retail competition was available, at least in theory, from day one, competition in Britain was planned to be phased in over eight years. How far this delay was due to the expected practical difficulties in implementing a complicated system more quickly, and how far it was to protect the markets of the newly privatised companies at least until they had gained some commercial skills is not clear. The first phase on April 1 1990, which involved the 5000 largest consumers, 30 per cent of the market, went smoothly. The privatised companies, including the generators, were keen to prove their commercial skills by competing for new customers and the customers had large enough bills that they could afford to shop around carefully for the best deal. Ironically, the largest consumers lost a government subsidy and actually ended up paying more for their power. The next phase in 1994 added a further 50,000 consumers (20 per cent of the market). This market segment also made commercial sense because bills were still large enough for it to be worth consumers shopping around and for retailers to try to win their business (the generators were not prominent in this market). In practice, this phase was badly done and for the first two years, the computing systems were in chaos and consumers switching supplier often did not receive a bill for up to two years.

Retail competition for small consumers was always going to represent a challenge of a much greater order. Competition for all was scheduled to be available from April 1 1998, but various problems, especially delays in completing the data processing systems required, have meant that it will not be till the summer of 1999 that all consumers will be able to choose. It is far from clear how successful this experiment will be for a number of reasons, some practical, some fundamental.

1. High cost. The cost of developing and operating the computer systems to allow charging of use of system etc. that will be passed on to consumers over 10 years will be about £720m (US$1200m) or about US$60 per consumer (the RECs claim they have spent more) whether or not they choose to take advantage of the option. Some argue that the costs need not have been so high, but that is what consumers will pay and if competition is to be judged a success, savings will have to exceed this figure.

2. No 'Smart' Meters. From experience with larger users, 'smart' meters cost around US$300 per year to rent, maintain and provide data processing for. Even if this figure proves three or four times too large, it is still much higher than prospective savings from time-of-day pricing, and so 'profiles', as in Norway will be used. This is a poor second best and removes one of the significant advantages of liberalisation, the opportunity to send price signals to consumers.

3. Low Margins. A residential consumer's bill comprises about 65 per cent generation cost, 25 per cent distribution cost, 5 per cent transmission cost and 5 per cent retailer's costs. Distribution and transmission are monopoly costs which will be the same for all suppliers. It is hard to see, if retail and generation are not integrated how one supplier can buy power in bulk more cheaply in an open market than another, so it will be hard to compete on generation cost. This leaves perhaps US$30-40 of revenue per year on which to compete. This has to pay for advertising and discounts to lure in new consumers as well as the direct cost of retailing (meter reading, billing and electricity purchase). As a result, in Britain, discounts for switching electricity supplier are low and the deals on offer generally involve purchasing gas and electricity as a package with most of the savings coming from gas.

4. Consumer Indifference. Even where large discounts are on offer for utility services, for example in Britain, up to 25 per cent was on offer to switch gas supplier, most consumers will not consider switching. Three years after competition in gas began to be phased in, less than 20 per cent of consumers have switched supplier. This appears to be in part because they do not understand the process (will they have to be re-wired or re-connected?), they assume, often rightly, that the head-line discounts are misleading, they are wary about switching to an untried supplier for such a vital service, and they have more interesting things to do with their time than choosing an electricity supplier. If experience with telecoms is anything to go by, the few consumers that do change are likely to be so exhausted by the process, they will not look at prices for another seven years or more. A cynical company will offer a low price for a year or two and then exploit the inertia of the consumer with high prices for the next few years.

5. Equity Issues. 'Cherry picking', that is, targeting groups of consumers with high consumption and good payment records, is inevitable. It remains to be seen whether regulatory oversight will ensure that the adverse effects of this can be kept within acceptable bounds.

It is worth explaining why large discounts have been available in the gas market and some degree of switching has occurred. In the gas industry, there was no regional structure of suppliers to final consumer. British Gas was the only supplier. Before the introduction of competition, it had an obligation to purchase as much gas as Britain needed from North Sea suppliers. As a result, it had a portfolio of contracts going back more than 20 years which by current standards look very expensive, perhaps 40 per cent above current market price. New competitors could easily undercut this price. The new competitors were nearly all RECs, often in collaboration with a North Sea gas producer - there was no policy against allowing vertical integration in gas.

This may be an important lesson for Finnish electricity suppliers. In Britain, the government placed a higher priority on making competition appear to work than on treating the existing suppliers fairly. As a result, British Gas had to be split up into a highly profitable pipeline and production company and a gas retail company which came very close to bankruptcy and take-over by one of the oil giants.

Consumer choice will not be abandoned, this would be politically infeasible, but the market for small consumers is likely to remain a de facto monopoly that suppliers will be able to exploit to cross-subsidise the more dynamic parts of the market. The most likely outcome is that retail and generation will become integrated, giving the semblance of a competitive market. However, this will mean that the wholesale market for electricity will have little significance, an independent retail sector will not be able to survive and that the barriers to entry for new generators will be high.

Re-Regulation.

The government and the Regulator predicted that regulation, which it was claimed would be independent of government, would be a 'light' and diminishing force as competition took over. Monopoly prices would be set using a simple incentive formula (RPI - X) and competitive markets would need no special regulation. In Norway, traditional rate-of-return regulation was chosen for the monopoly elements.

There has been a great deal of interest generated in British regulation based on a perception that the British method allowed a much simpler, but more effective and independent process than traditional methods. This view is fallacious on three grounds. First, the major change was to try to make generation and retail competitive markets, which, if successful would mean that routine regulation of these parts of the business would not be required. Regulation of the remaining monopolies was bound to be much simpler whatever method was used. In practice, the Regulator has spent much of his time regulating the apparently competitive markets. It is not clear whether this work-load will diminish as the markets mature.

Second, British experience suggests that the regulatory 'incentive' formula (RPI - X) quickly becomes rate of return regulation in a different presentational form. The British process of monopoly regulation is now explicitly based on valuation of assets, assessment of investment needs and determination of an appropriate rate of return for the existing assets and the new investment - the same steps as rate-of-return regulation.

Third, the Regulator has never been independent of government. Apart from the obvious fact that he is appointed and is dismissable by the relevant government minister, the legislation states that all his major powers are jointly held with that minister. Recently, in the water industry, the minister has begun to exploit his joint powers to force down prices. If conflicts between the Regulator and minister were to emerge, there is little doubt who would come out on top.

Some changes to the regulatory system are underway which may make some practical differences. First, the responsibility for consumer representation and complaints is to be taken away from the Regulator and placed with a new separate body, as is the case with gas. Second, gas and electricity regulation are to be merged. This makes obvious sense given that the gas and electricity are now so closely interlinked and that regulation of a gas pipeline differs little in principle to regulation of an electricity cable. Third, the Regulator's primary duty is to be changed from 'promoting competition' to 'protecting consumers'. However, since the Regulator has frequently stated that the best way to protect consumers is to promote effective markets, it is hard to see what practical implications this has. Fourthly, the system of regulation by a single individual is to be replaced by introduction of a Panel or of senior advisers - the details have not yet been published.

Overall, there is no universal formula for regulation. Regulatory bodies will always fit in with national styles - US regulation will always be legalistic and British regulation will always be more informal and flexible - some might say amateurish. The British experience provides some insights but it is not revolutionary nor is it a model that can be simply transplanted elsewhere.

Changes of Ownership

Amongst the unexpected events that had to be taken account of, the wave of merger and take-over activity that occurred from 1995 onwards was probably the most important. One of the public's concerns the government had to take account of in its privatisation programme was that key national assets would fall into foreign hands and would be exploited to the detriment of Britain. Important companies were therefore privatised but leaving the government with a 'Golden Share'. This effectively allows the government to block take-overs, although it does not prescribe take-overs altogether. In the electricity sector, the Golden Shares on the generating companies and the NGC still apply, and it has been used to rebuff an approach in 1996 by the US Southern Co to take over National Power. But for the RECs, these expired in March 1995.

At the time of privatisation, it was expected that there would soon be pressure for mergers between the RECs. However, no proposals for merger have come up. Within about a year of the expiry of the Golden Share, all 12 RECs had been the subject of take-overs. Now, none of them is an independent company, some having been taken over more than once, more than half are now owned by US utilities and the British generators have also been active bidders. However, most of the US-owned RECs are known to be up for sale. Four questions arise: why did the British government not intervene more to moderate the process; why were the RECs such apparently attractive take-over targets; why did US utilities and British generators so dominate the bidding; and why are US utilities now so disillusioned?

The British government seems to have been taken by surprise at the speed of the process. By inclination, it was reluctant to intervene in market processes especially given that one of the stated objectives of the reforms was to remove government interference in the sector.

The attractiveness of the RECs lay in their record of high profits due to the very weak pressures the original government pricing formula placed on them. It was also based on a perception that the Regulator, in subsequent revisions to the formula, was too weak to impose prices which would be difficult to achieve. In 1995, the formula for the main element of the RECs' business, distribution which accounts for about 90 per cent of their profits had been set for the next 5 years at readily achievable levels. The main income stream for the RECs was therefore entirely predictable until 2000. At worst, the new owners could take five years of easy profits and then walk away. For the US utilities which were facing liberalisation in their own markets which would inevitably reduce their market share there, these represented an opportunity to expand their business, make easy profits and to learn in advance about the way competitive markets operate.

For British generators, which were losing market share in the generating market because of the impact of REC-owned plant, Regulator enforced plant sales and extra nuclear output, these represented an opportunity to replace the business lost. More important, it was an opportunity to acquire a set of more or less captive consumers to reduce the risk their generation businesses would increasingly face.

In 1996, the government blocked attempts by PowerGen and National Power to take over RECs. However, it allowed the REC, Eastern, to become a major generator and allowed the larger integrated Scottish company, Scottish Power, to acquire a REC (Manweb). In 1998, the other integrated Scottish company, Scottish Hydro, has also acquired a REC (Southern Electric) and government has allowed National Power and PowerGen to integrate. PowerGen has bought a REC, East Midlands Electric, and National Power has bought the retail part of Midlands Electric. British Energy is actively looking to buy a REC and was outbid by EDF for London Electricity.

For the US utilities, the balance of the motives in buying RECs was always difficult to determine and it is not clear they understood the British system (political, technical and regulatory) as fully as they claimed when they placed their bids, mostly in 1995-96. The Labour government enforced a windfall tax in 1997 to recover some of the excess profits made by electricity companies since privatisation. The US utilities probably expected to be able to avoid or reduce this tax. The Regulator began to enforce pricing formulae which, by any standards, were tough. With a new distribution formula due this year, the US utilities, surprised by the toughness of the regulatory regime, may simply want to get out before the formula is announced and the value of their assets goes down. Of the US owned RECs, East Midlands, London Electric and part of Midlands have been sold already, and SWEB, SEEBOARD and Yorkshire are probably for sale.

The proposal to split the RECs into two would create a further difficult choice for the owners. Distribution is a large business (90 per cent of the RECs' turnover), but it should be a low risk low profit business with little scope for growth and no synergies with other parts of the industry - hardly worth crossing the Atlantic for. Retail is a much smaller and riskier business, but with much greater scope for high profits and growth. It also is a good partner if a generation business is being built up, reducing risk in both sectors.

The future ownership of the British generation and transmission companies is cloudy. With National Power, PowerGen and NGC increasingly active outside UK and the two generators less dominant in the UK, the justification for the retention of the Golden Share looks thin and these companies might come up for sale.

Conclusions and Lessons From Britain

There have been Benefits to Consumers

After a period when prices were kept high by weak regulation of the monopolies and a highly concentrated generation market, some real price benefits from privatisation, mainly from pressure on the monopoly prices, are beginning to be felt. The main price effects are, however, little to do with the introduction of competition: they result from low gas and coal prices (40 per cent lower in real terms for gas, more for coal) and the use of CCGTs - this does not prevent advocates of the British model claiming these price reductions as a benefit of competition. System security seems not to have been adversely affected and utilities are now much more 'customer-friendly' than before.

Traditional Government Energy Policy is now Difficult (Impossible?)

The British coal and nuclear industries are now in irreversible decline, in the nuclear case despite the best efforts of government, and subsidies for large consumers could not survive. System planning is incompatible with free markets, although so far, the pressure to build new gas plants has meant that capacity shortage has not arisen. The Labour government is now trying to control the rate of introduction of gas in order to save what remains of the coal industry, but this is proving much more difficult than they expected. Utility R&D has effectively disappeared.

The British Model is a Myth

There has been much talk of the British Model and consultants have been active world-wide selling the British Model to developing countries. This is a shabby business. It generally involves restructuring and sale of national companies to international bidders, but the introduction of competition, which was an integral element of the British system, is generally not part of the reforms.

It is far from clear what is meant by the British model, but if it implies a de-integrated structure with competition in generation and in retail supply, this never has and probably never will exist in Britain. Indeed, there are three separate models in Britain, that covering England and Wales described here, but there are also separate systems with different structures in Scotland and Northern Ireland. Clearly some competitive forces apply now in generation and retail supply, but they cannot be described as markets and there are strong reasons for doubting whether proper markets are possible.

Gas in Combined Cycle Plants is the only Generation Option

The risks that are now inherent in the generation market are reflected in the real rate of return on capital that generators now look for on new projects, up to 15 per cent real. Only low capital cost options with equipment whose cost and performance can be guaranteed can be considered and this means gas-fired CCGTs or perhaps small-scale CHP if suitable industrial partners are available. Large coal, nuclear, and hydro are impossible.

Methods in the Electricity Supply Industry have been turned upside down

Nearly 10 years after privatisation, almost all the procedures of the industry have been revolutionised In Britain, there has been a massive reduction on employment, about 50 per cent, in the industry, particularly in the generators. It is difficult to divide these losses up between the effects of new generation technology, technical progress that would have occurred anyway, the abandonment of R&D programmes and of central planning departments, the re-labelling of employees as contractors, and genuine productivity improvements. However, work in the electricity supply industry is no longer the job for life it once was.

The Issues of Take-over and Merger were not Addressed until it was too late

The wave of take-over bids for RECs took the government by surprise and decisions were taken without proper thought being given to the issues of regulation, monopoly power and loss of national control these raised.

Experience in the Rest of Europe

Despite the proximity to the revolutionary experiments in the Britain and the Nordic countries, despite much of the rest of the World beginning to adopt a liberalised structure and despite the efforts of the European Commission, much of the rest of Europe remains little affected in important respects by these changes. Most utilities in Europe still enjoy the monopoly power to plan their system and pass on all costs to their consumers, and they seem to be observing a tacit non-aggression pact under which they will not threaten neighbour's markets in return for a free run in their home markets.

In France, Italy, Greece and Ireland, the nationally owned monopolies are still in control. In the case of France, this is due to the dominance of nuclear power and the use of EDF as a way of promoting French exports; in Italy, the weakness of central government and the chaos in the sector make reforms difficult to push through. In Greece and Ireland, the nationalised utilities are amongst the largest companies and major employers in the country. Breaking up and weakening them is a very serious step.

In Germany and Belgium, regional or national monopolies are protected by the immense political power and influence of the companies. In Spain and Portugal and also Austria, apparently large structural changes have occurred but control of the system still lies in the same hands. In Denmark, the government's environmental agenda is the dominant force and cannot easily be reconciled with a free market in electricity. Only the Netherlands is actively pursuing a policy of comprehensive reform, ironically, because of inadequacies with an earlier reform completed in 1987.

Four areas are worthy of comment. Will the EU Electricity Directive be effective? Why did the Dutch liberalisation fail and what issues do the new proposals raise? Are 'national champions' in the electricity supply industry going to re-emerge? Will the Nordic market work?

The EU Directive

It is easy to dismiss the Directive as feeble and ill thought out. For example, according to the Directive, it will not be until 2005 that consumers in the rest of Europe will be allowed as much freedom of choice as has been available in Britain since 1990; and the way in which the Single Buyer option will operate is still a complete mystery. However, experience in the USA with the PURPA legislation and in the Netherlands with provisions on CHP in the 1987 Electricity Act shows that apparently small loop-holes can be prised open to effectively destroy a system. Two forces should be taken special note of. First, large consumers have immense political power and if they believe that opening the market will give them a better deal, it will be difficult to stop them using the Directive to further their own ends. Second, there is a growing field of international utilities looking to expand their geographic coverage. The economic stability of Europe and the mature nature of the electricity systems make Europe a very desirable place to invest. Particularly if the 'non-aggression pact' is broken, utilities from inside or outside Europe could use the Directive to obtain access.

National Champions

There are signs that European governments are looking at the result of reforms in countries such as Britain, the Netherlands and developing countries adopting the 'British model', and becoming very nervous at the prospect. On the one hand, they fear the take-over and loss of control of their electricity supply industries and on the other, they see the destruction of the national electricity supply industry as a lost opportunity for local companies to compete in world markets. In a number of countries, there are signs that 'national champions' will be protected in some way, or even allowed to emerge. For example, EDP (Portugal), ENDESA (Spain), the Verbund (Austria) are getting stronger and it is not hard to think of other potential national champions in other countries. In the Nordic region, will the governments back companies such as Vattenfall, Statkraft and IVO when moving into international markets and prevent them from losing their home market to foreign competitors? In allowing national champions to emerge, governments will have to be careful that they do not abuse their position in the home market to underwrite foreign ventures.

The Dutch Reforms

In structural terms, the 1987 Dutch reforms looked good. The system remained fully in local public ownership, but the structure was de-integrated with multiple players in the potentially competitive areas. However, the distribution and retail companies owned the generators which in turn owned the transmission company. In practice there was no competition. SEP, the transmission company but also a planning agency with strong ambitions to dominate the whole system, tried to run generation on a centrally planned co-operative basis, controlling international trade. The distributors exploited loopholes allowing CHP to reduce the power of SEP to the point where it appeared that most of the large, centrally dispatched power plants would become redundant. They also successfully challenged SEP's monopoly in international trade. Mergers between distributors threatened to reduce their numbers sufficiently to create an oligopoly

It is not clear what the final shape of the new system will be, but privatisation is now on the agenda, as well as take over by foreign utilities. A potential outcome is that the Dutch could lose nearly all their large central power stations (these would be owned by a single company) and rely solely on CHP and imports of power. This is causing some soul-searching in the Netherlands as to whether this will provide a reliable power system.

Will the Nordic Market Succeed?

Rather than try to answer this question, I would like to pose a number of questions.

Is Public Ownership Desirable and Sustainable? There is a striking contrast between the very orderly, co-operative Nordic market and the chaotic British market where loopholes and weaknesses are mercilessly exploited. It is not clear how far this is due to better system design and cultural factors, and how far it is due to the moderating effect of public ownership. While change of ownership was no part of the reforms in the Nordic region, cross-ownership between countries is beginning to occur for strategic reasons. As utilities lose their local base and local authorities begin to think of uses for the money they could raise from selling the utility, it is not difficult to see a progression of loss of local ownership, followed by privatisation and entry of utilities from outside the Nordic region.

What happens if Large Consumers Suffer? The Nordic economies are heavily dependent on industries, metal manufacture, chemicals and wood products, which rely on access to cheap power. The logical conclusion of the European reforms is that the Nordic market will become absorbed into a European market with a European electricity price. In such a situation, it will be no more possible to give local industries cheap electricity than it is for Britain to give its industries cheap oil.

Is Investment in New Generating Capacity Possible? One issue not yet faced in the Nordic market is whether investment in new capacity is possible. As utilities in the rest of Europe get increasing access to cheap Nordic power, there will be a need for new generating capacity, especially if the Swedish nuclear phase-out ever begins. British experience suggests that new capacity will only be possible with low risk, low capital options with strong contractual cover, effectively gas or CHP. However, there is the complicating factor of an environmental agenda not present in the Britain. Nuclear, large-scale hydro and coal are out of the question on environmental grounds, the scope for energy efficiency is probably less than in other parts of Europe, and even gas raises issues. Expensive pipelines from Norwegian fields would probably be needed and the carbon dioxide targets would be difficult to meet if gas was chosen.

Conclusions on the Rest of Europe

The EU Directive is weak but may be sufficient to break the power of traditional utilities

There is no evidence that by itself, the Commission has the power to enforce a radical liberalisation of the electricity supply industry. However, there are powerful forces, such as large consumers seeking lower prices and predatory international utilities, which will be able to use the provisions of the Directive to break the monopoly powers of the traditional utilities. Few governments now have the political will to defend the status quo.

National Champions will be growing international forces

Defending local electricity monopolies will become increasingly untenable and the large utilities will increasingly see their future as being a strong player in an apparently liberalised home market and a major competitor in international markets. This will suit many governments as it will leave a strong player in the home market through which government policies can be channelled if necessary, and will also leave a strong company which can benefit the national economy by competing in international markets.

The Dutch Reforms will be a good test of whether the market and decentralised options really can ensure secure supplies

Factors such as size, geographic isolation and comparative advantage in electricity generation have meant that the Nordic and British models have not yet fully tested whether the market can deliver secure electricity supplies. In the Netherlands, it is possible that the companies operating the Dutch centralised generation sector could almost completely disappear, leaving the system to be supplied by IPPs, CHP and imports.

The Nordic Market is by far the most successful liberalisation, but it is still far from proven

The Nordic reforms have been highly successful so far, reducing prices by increasing trade and improving the utilisation of facilities. However, privatisation may now be inevitable, new generating capacity will soon be needed and, ultimately, the economies of the region could be damaged if traditional industries become uncompetitive.

The Corporate Dimension

Throughout its history, the electricity supply industry has been almost unique in being operated by national companies, whose only business of any consequence was electricity and which operated solely within national boundaries. This made control, regulation and planning of the industry simple: governments could either direct the companies where they were nationally owned or, through the 'regulatory bargain' (the companies would be assured profitable operation in return for ensuring the security of the system), they could ensure their objectives were carried out.

This situation clearly will not apply in the future. The companies are already becoming international in scope and correspondingly more difficult to regulate. However, it is not yet clear whether electricity supply industry interests will become a typical part of a diversified multinational - there is no sign yet that this will occur. In the oil industry, the multinationals dominate the business and have proved supremely successful at delivering high profits to their share-holders. But attempts to diversify have almost always proved unsuccessful. However, the logic of combining an electricity business with a gas business, at least the down-stream end of it, seems compelling.

In the 70s and 80s, the corporate fashion was for diversified companies with the accent on management rather than on interlinkages between the components. The strength of large corporations was seen to be management and any company, whatever sector it was in, which was not fulfilling its potential was a possible take-over target to be shaken up and perhaps sold on. Now the accent is on 'synergies', that is finding businesses which can feed, technically or commercially, on core competencies. In order to understand how the new breed of electricity company will behave, it is necessary to examine the component parts of the electricity supply industry and see how they fit with each other and with other sectors of the economy.

In a reasonably well regulated system, ownership of the infrastructure gives little or no commercial advantage to generators or retailers and the technical overlap seems limited. With mature electricity supply systems as in Europe and North America, running the infrastructure involves maintenance, repair and replacement of a network. Growth will be minimal unless take-overs are possible. There are clear technical synergies between the transmission and distribution businesses. However, the creation of a national distribution monopoly would make regulation more difficult by taking away the possibility of yard-stick regulation and would probably be resisted on those grounds. Technical synergies may exist with other network or co-ordination industries and for example, the NGC has developed a strong telecoms business, Energis, and is bidding to take over the British air traffic control system. The move by grid companies into telecoms is common throughout Europe but it is worth noting that the commercial characteristics are very different. Telecoms is a high risk business with long horizons - several unprofitable years are likely to a new entrant while their market is being developed. This may explain why NGC is selling its stake in Energis.

Electricity distribution may fit well with gas and water distribution. In Britain, two of the RECs were taken over by water companies. There are suspicions that these acquisitions had more to do with finding a way to invest embarrassingly large profits in a safe business rather than long-term strategic thinking, but the companies may still develop as infrastructure suppliers.

The generation business, in a liberalised market is a high capital, high risk business for which the nearest analogies are probably continuous processes producing homogeneous products such as bulk chemicals or steel. In isolation, the retail business is an unusual one requiring negligible capital - a telephone and a personal computer is all that is required. However, the risks are immense to a new entrant, which must rely on skills in trading commodities and in marketing to final consumers.

However, the commercial synergies between the retail and generation sectors are strong, as is demonstrated by the desire of the British generators to integrate into retail and retailers into generation. British experience also suggests the gas and electricity retail businesses fit well together. How far generators should integrate into up-stream gas is less clear. Some of the British generators are now withdrawing from gas production activities they had earlier bought into, but clearly generators do need skills in buying and selling gas and, for example, companies such as Eastern and Enron pride themselves on their ability to arbitrage gas between markets.

For companies in the electricity sector to expand geographically, it may be useful to demonstrate skills in all aspects of the electricity value chain, so that if attractive companies do come up for purchase, it is possible to demonstrate a track-record in all the relevant skills. For example, PowerGen's acquisition of a REC allows it to claim a proven record in operating a distribution network and a retail supply business.

Particularly in the developing world, there is a bandwagon effect, driven by the International Financing Institutions, to restructure the electricity supply industries. Corporations such as the Southern Company, Endesa, Enron and EDF are acquiring an aura for having skills which, in reality, are not special. It should be recalled that much of the impetus for the USA to restructure its electricity industry comes from the failures of the very utilities, such as Southern Co and Houston, that are beginning to become global forces in this market. It is arguable that the special skills necessary for oil exploration and production justify the dominance of the oil majors. It is also arguable that scale economies justify the diminishing number of car or aircraft companies. But does the complexity of hamburger production or scale economies justify the dominance of MacDonalds or are we just falling for the power of the brand name? Electricity production and distribution are well understood, mature businesses, with much less scope for technical change and growth than, for example, telecoms. It has limited scale economies and, in Britain, the adoption of CCGT technology has demonstrated that a company with one plant can be as efficient as a company with 20 plants. Most countries, and all developed countries have the resources to do operate an electricity supply industry as well as the best.

If the 'Seven Sisters' of the 21st Century do turn out to be the electricity majors, will national regulatory regimes have sufficient power to negotiate a good deal from them? The move towards 'national champions' noted above may cause regulatory problems, but they may be much of a much lower order than those a concentrated multinational electric utility industry would pose.

Conclusions on the Corporate Dimension: The corporate changes that will result have hardly started yet

The infrastructure parts of the business will soon become separate

There will be increasingly little corporate advantage, and strong regulatory pressure to prevent the competitive and the monopoly parts of the business being integrated within the same company.

The industrial logic for integration of electricity generation, electricity retail and gas supply may be irresistible

Integration of generation and retail may be undesirable from a competition viewpoint, but a de-integrated system, with sufficient number of players to ensure a competitive market may be too commercially risky to be sustainable. Gas will become the overwhelmingly dominant fuel for generation and retailing gas has obvious synergies with retailing electricity.

Large international electricity corporations will emerge and try to dominate the global industry. This is undesirable.

The bandwagon of liberalisation is now unstoppable and the large US and European utilities are already dominating the electricity supply industries in developing countries. As developed countries liberalise, they will try to move in here. There is no industrial logic behind a highly concentrated global electricity sector, and severe competitive and regulatory disadvantages.

Structure
	Desired	Pre-1990
Generation	Many competitors	Central Electricity Generating Board
Retail	Many competitors	12 Regional monopolies (Area Boards) (passive price takers)
Distribution	Independent regional monopolies	12 Area Boards
Transmission	Independent national monopoly	Central Electricity Generating Board

 

Structure
	Desired	1990
Generation	Many competitors	Two dominant companies (Nuclear company a price taker)
Retail	Many competitors	12 Regional companies (RECs)
Distribution	Independent regional monopolies	12 RECs (Separate accounts required for retail)
Transmission	Independent national monopoly	National monopoly (Owned but not controlled by RECs)

Structure
	Desired	1999
Generation	Many competitors	Five main generators (fears still of market dominance in 'price-setting' plant)
Retail	Many competitors	12 RECs still dominate (Retail businesses being bought by generators)
Distribution	Independent regional monopolies	12 RECs (Attempts by Regulator to force full separation of retail and distribution)
Transmission	Independent national monopoly	Independent national monopoly

Structure
	Desired	2001
Generation	Many competitors	4 or 5 main generators ((National Power, PowerGen, Scottish ¿National Power, PowerGen, Scottish Power, Eastern, ? British Gas, EDF?)
Retail	Many competitors	4 or 5 companies owned by generators(All sell gas and have alliances with supermarkets, banks, etc.)
Distribution	Independent regional monopolies	33 or 4 monopolies
Transmission	Independent national monopoly	Independent national monopoly

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