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Regulating Electricity Markets: Experience from the United Kingdom

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Page 1: Regulating Electricity Markets: Experience from the United Kingdom

December 2001

© 2001, Elsevier Science Inc., 1040-6190/01/$–see front matter PII S1040-6190(01)00258-5

81

Regulating Electricity Markets: Experience from theUnited Kingdom

The Competition Commission’s rejection of the appropriateness of the Market Abuse License Condition special-powers clause demonstrates the inappropriateness of an “I know abuse when I see it” approach to the regulation of business conduct by firms with market power.

Simon Bishop and Ciara McSorley

he California power crisis has highlighted concerns

over the alleged exercise of mar-ket power by generators in whole-sale electricity markets. While in California the root cause of the crisis has been a shortage of generation capacity, concerns over market power have been expressed in other markets which do not suffer from such shortages. This article deals with the recent experience in the United Kingdom, where the energy regulator, the Office of Gas and Electricity Markets, or Ofgem, attempted to introduce a new condition into the generation licenses of U.K. generators to

combat the exercise of “substan-tial market power.”

While Ofgem already hadpowers to intervene against abuses by dominant firms under the U.K. Competition Act (“the Act”), it argued that these powers were insufficient to protect U.K. con-sumers against the exercise of mar-ket power by electricity genera-tors. To remedy this perceived deficiency, Ofgem proposed to award itself wide-ranging powers under the so-called Market Abuse License Condition (MALC). Ofgem proposed initially to intro-duce this condition into the license of the eight largest generators. Of these generators, only AES and

Simon Bishop

is a Director ofNational Economic Research

Associates, London, and has beenadvising clients on competition policy

issues for over 10 years. He has workedon over 100 cases primarily before the

European Commission and U.K.competition authorities. He has advised

major companies in a large number ofindustries including satellite and cable

television, telecommunications,newspapers, airlines, pharmaceuticals,sports, brewing, numerous industries

with branded consumer products, steel,electricity, and water. He has

experience as an economic adviser oncases before the European Commission,

including the Merger Task Force, theU.K. Office of Fair Trading and the

Monopolies and Mergers Commission,the Polish Anti-Monopoly Office, and

utility regulators.

Ciara McSorley

is a consultant atNERA’s London office and worked with

Mr. Bishop as part of the economicsteam defending AES Corporation in the

U.K. Competition Commissioninvestigation. She has a master’s degree

from the London School of Economicsand has five years of experience on

competition investigations.

T

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British Energy sought to challenge Ofgem by exercising their rights under the U.K. Electricity Act of 1989 and appealing to the U.K. Competition Commission.

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This Commission, the U.K. competition authority, was given the task of deciding whether the MALC was necessary to protect the interests of U.K. consumers.

n December 2000, the Competi-tion Commission issued its

findings and unexpectedly rejected outright Ofgem’s MALC.

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This article considers the strength of Ofgem’s arguments and the les-sons that the Competition Com-mission’s conclusions have for both the general application of competition law and the regula-tion of electricity markets.

I. The U.K. Electricity Market

Ofgem’s proposed new regula-tion came at a time of consider-able upheaval in the U.K. electric-ity generation market. For almost the first decade after privatiza-tion, the generation market had been highly concentrated, with generation assets, and particu-larly the coal-fired plants that set the system marginal price in the England and Wales Electricity Pool (“the Pool”), in the hands of only two (and after 1996, three) competitors. Many commentators criticized this concentration of generation ownership as leading to insufficient competition in gen-eration.

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In 1999, this concentra-tion of generation assets was finally addressed by forced divestments from National Power

and Powergen, the two largest generators. These divestments were specifically designed to increase competition in price-setting, and consequently concen-trated on coal-fired assets. The changes these divestments made to the structure of the market are shown in

Table 1

.The table shows the market

shares of the England and Wales generation sector based both on capacity and on price-setting in the Pool. The Pool is a compul-sory marginal bid system where all capacity must be bid into the system and where the marginal bid used sets the price used for all. Whereas in 1996 the two largest generators accounted for approximately 60 percent of capacity, in 2000 the divestments meant that the two largest genera-tors accounted for just over 30 percent of capacity. Competition in price-setting was also

increased. In 1996, the two largest generators set price 70 percent of the time, in 2000 the two main price-setting generators set price just 40 percent of the time and an additional four generators each set price more than 10 percent of the time. According to indepen-dent experts, this reduction in concentration had significantly reduced the potential for market abuse.

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In addition, it is worth noting that relative to the situation in Cal-ifornia this past year, there is no shortage of generation capacity in the United Kingdom. The National Grid estimated that in 2000 the plant margin was 28 percent above peak annual demand.

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The old Central Electricity Generating Board had a target plant margin of 24 percent—the National Grid now estimated that a plant margin of 20 percent was sufficient to ensure supply.

Table 1:

Structural Impact of National Power and Powergen Divestments

Shares of CapacityProportion of Price-Setting by Company

1995/1996 1999/2000 1996 2000

Powergen 28.1% 16.5% 31.8% 16.8%

British Energy 12 14.8 0 4.9

National Power 33.7 13 44.8 14.6

TXU 1.6 9.2 7.3 11.8

Edison 3.8 8.9 13.2 21.1

AES 0.5 7.6 0 19.3

BNFL Magnox 5.8 5.4 0 0

EdF 3.3 3.3 0.7 10.7

Scottish Interconnector 2.3 2.2 1.7 0.4

Combined cycle gas turbines 7.8 17.2 0.5 0.4

Others 1.3 2 0 0

Total

100%

100%

100%

100%

Source:

Ofgem.

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II. The Market Abuse License Condition (MALC)

Despite these changes in market structure, Ofgem was still con-cerned about the potential for abuse of market power in the gen-eration sector. Ofgem conse-quently proposed a license condi-tion that would have reinvented competition policy for the electric-ity sector. The MALC would have created an obligation on each gen-erator not to abuse a position of substantial market power, where substantial market power was defined as “the ability to bring about, independently of any changes in market demand or cost conditions, a substantial change in wholesale electricity prices.”

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A substantial change might refer to both large changes in prices over a short period of time or smaller price changes over a longer period of time. The Director General of Ofgem stated that the inclusion of the MALC in a generator’s license would not imply that the firm did enjoy substantial market power and, moreover, it was the abuse of substantial market power, not its mere existence, that gave rise to problems.

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fgem justified its need for this wide-ranging condition

by arguing that the special charac-teristics of electricity generation implied that even firms with as little as 5 percent of generation capacity could at certain times act anticompetitively by being able to price above competitive levels (what Ofgem termed “close to real-time market power,” although it failed to provide a definition of the

term). The two generators under investigation enjoyed market shares of between 8 and 18 per-cent, depending on the measure used, thus making them, in Ofgem’s eyes, potential perpetra-tors of anticompetitive conduct. Although it had concurrent com-petition powers under the U.K. Competition Act of 1998, which protected against anticompetitive behavior in all sectors of the econ-omy, Ofgem argued that such

U.K. electricity regulator would have identified a blind spot in competition law—the inability to tackle abuses of market power by nondominant firms—and as such the MALC would have wider implications than the U.K. electricity market.

III. When Might an Effects-Based Approach Work?

The effects-based approach embodied in the MALC has some superficial attractions and might appear to mirror an approach that is often advocated in the assess-ment of mergers. In merger cases, the central concern is to identify whether the merger makes the market less competitive than it would otherwise be. That is sel-dom if ever an easy task, but at least it is, in principle, a well-defined one, especially when the pre-merger past is a reasonable guide to what the future would look like absent the merger. In that case, the assessment of the impact of the merger can be conducted against a clear benchmark: Will the postmerger world be worse than what we have now?

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here have been several merger cases where, due to the char-

acteristics of the market or the countervailing power of buyers, or due to the existence of a high degree of product differentiation, market shares provide a poor guide to market power. This implies that the definition of the relevant market (whose essential purpose is to enable the calculation of shares) is at best problematic, and at worst counterproductive. In

The effects-based approach embodied in the MALC has some superficial

attractions.

powers were inadequate for addressing these concerns. In par-ticular, Ofgem argued that since the Act was based on the prohibi-tion of the abuse of a dominant position, it was necessary to first establish that the firm or firms in question had a dominant position before action could be taken. Given AES and British Energy’s market shares, however, it was unlikely that they would ever be found to be dominant. In conse-quence, Ofgem was concerned that the alleged anticompetitive con-duct of these two firms would never be caught.

If Ofgem were correct, then the

O T

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All firms subjectto regulation have

a right to someguidance as towhat behavior

is permitted.

such circumstances, an effects-based approach—going straight to the assessment of the merger’s impact—can often provide a truer reflection of the nature of competi-tion and of how it might be affected by the merger.

hen it comes to analyzing alleged abuse and other

anticompetitive behavior, how-ever, the direct “effects-based” approach raises some serious practical difficulties that are not present in merger cases. The com-petitive assessment of a merger is typically concerned with whether the merger eliminates an impor-tant competitive constraint so that prices will rise, or equiva-lently whether quality falls. The use of the prevailing price level as the appropriate benchmark against which to assess competi-tive constraints has the advantage of not only being observable—one typically knows what the prevailing price level is in an industry—but also permits the use of a range of empirical tech-niques to asses the strength of competitive constraints at those levels. This applies whether one is conducting a direct assessment of those competitive constraints or only an indirect assessment (by defining the extent of the relevant market).

But the analysis is quite differ-ent in nonmerger settings where the assessment is focused on determining whether or not a firm’s conduct is abusive or anti-competitive. In those cases, the issue is often not whether the con-duct permits the firm under inves-tigation to raise prices above pre-

vailing levels, but whether that conduct has permitted prices to be increased above the

competitive level.

Typically, we do not know what the competitive price level is. If we did, the competitive assessment would become trivial—the competitive assess-ment would involve simply moni-toring whether the price rose above the competitive level and concluding that if it did, market power was being exercised. This

ding strategies which would both be acceptable under the condition and consistent with the firm’s nor-mal commercial objectives.

IV. The Competition Commission’s Analysis

This difficulty and its implica-tions for regulatory intervention based on an effects-based approach was a central issue in the Competition Commission’s inves-tigation of the public interest merits of the MALC. The Compe-tition Commission noted that while Ofgem had put forward a plausible definition of what the Director General would consider a substantial change in wholesale electricity prices (a key element in his definition of substantial mar-ket power), the benchmark from which the price increase would be measured was unclear. Asthe Competition Commission commented,

[the Director General of Ofgem] made it clear that he did not regard benchmarking to a compet-itive price as necessary to an investigation of abuse of substan-tial market power. He told us that he had no view as to what the cor-rect level of prices should be

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But this statement glosses over some thorny issues, and in effect reduces the regulatory process to one of “I know abuse when I see it.”

ll firms subject to regulation—even those with some mar-

ket power—have a right to some guidance as to what behavior is permitted and what is not. For example, how would one deter-mine whether a price spike—a

absence of a competitive bench-mark against which to evaluate alleged abuse raises serious prac-tical difficulties.

These practical difficulties cause problems both for the firms in the market and for the regulator. For the regulator, there is no clear benchmark for determining whether a specific price is competi-tive or abusive. For the firms, this lack of a benchmark creates con-siderable uncertainty as to whether their behavior will be deemed acceptable or not. As the acceptability or otherwise of a bid would be decided

ex post

it would be difficult for firms to devise bid-

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natural phenomenon in electricity generation markets—was the con-sequence of normal competitive behavior or the result of anticom-petitive market manipulation? That assessment cannot be made by comparing prices with underly-ing costs. It is clear that the short-run marginal cost of generation cannot provide the appropriate competitive benchmark. If that were the case then the generation capacity that existed only to meet occasional periods of high demand would never be able to recover its fixed costs.

Ofgem suggested that it would implement the MALC by compar-ing prices across two different time periods. But that technique does not provide a basis for saying that the price in either period is in some sense correct. As the Competition Commission noted, that approach also raises serious difficulties.

[Ofgem’s] technique enables a judgment to be made quickly as to whether prices in a particular period appear anomalous but it cannot answer directly the more fundamental question whether the level of prices in any period is inconsistent with the operation of a competitive market.

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Indeed, the Competition Com-mission did not consider it in-appropriate for a firm to price differently across time if market conditions permitted.

We take the view that it is normal commercial behavior for a profit-making company to increase its bid price when there is a disconti-nuity in the supply curve. This applies whether the discontinuity in the supply curve is continuous for a sustained period, say a year or more, or whether it arises over

a much shorter period as the result of outages of other genera-tors’ plant.

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Similar conceptual issues arise in many other markets where firms are required to recover large fixed costs across a range of separate transactions (whether those trans-actions are differentiated by time period, as in the electricity case, or by some other feature such as geography or customer category).

Because of the difficulty of distin-guishing between abusive and acceptable conduct, there is a risk that such a prohibition [i.e., the MALC] will deter normal compet-itive behaviour and thus inhibit the operation of the market. A dampening of price volatility, for example, could reduce the effec-tiveness of price signals and inhibit the development of more flexible responses from both the supply and demand sides.

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In effect, the Competition Com-mission recognized that the MALC did not provide sufficient safe-guards against unwarranted inter-vention on Ofgem’s part and that that would deter generators from competing effectively. The MALC, rather than safeguarding competi-tion, would actually be detrimen-tal to it. The Competition Commis-sion consequently rejected Ofgem’s claim that the absence of the proposed modification to the licenses of AES and British Energy would be against the public inter-est. Rather than protecting con-sumers, the uncertainty created by the MALC would potentially deter firms from behaving in a normal commercial manner.

oreover, the Competition Commission reached this

conclusion with its eyes open to the imperfections of the market. It recognized that competitive con-duct in the U.K. generation mar-ket had historically been prob-lematic, and that, despite continuing moves to reduce industry concentration and improve trading arrangements, the system would never be per-fectly free from some degree of game-playing by the partici-pants. But it also recognized that

Similar conceptual issues arise in other markets where firms are required to recover large fixed costs across

a range of transactions.

Observing variations in price-cost margins between these transac-tions (i.e., that the firm engages in price discrimination) indicates nothing more remarkable than that the industry departs from the text-book paradigm of

perfect

competi-tion. By itself, that tells us nothing about the existence or exercise of substantial market power.

Given this difficulty, the Compe-tition Commission was concerned that the introduction of the MALC into the generating licenses of AES and British Energy would lead to significant uncertainty, that would in turn have adverse effects for competition.

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Ofgem’s blueprint for micro-control of competitive conduct would do more harm than good.

V. Lessons for Regulation and General Competition Law

The Competition Commission’s robust rejection of the appropriate-ness of MALC provides a number of important lessons. Above all, it demonstrates the inappropriate-ness of an “I know abuse when I see it” approach to the regulation of business conduct by firms with market power. Such an approach, even if well-intentioned, provides no benchmark against which com-petitive behavior can be distin-guished from anticompetitive behavior. The Competition Com-mission recognized that this absence of any analytical frame-work would expose firms operat-ing in nearly all industries to almost limitless and unpredictable regulatory intervention. The costs of such intervention in terms of uncertainty and confused incen-tives are likely to outweigh any notional benefits from fine-tuning regulation of business conduct.

n rejecting Ofgem’s request for the introduction of MALC into

the generation licenses of AES and British Energy, the Competition Commission provides a welcome reminder that competition law intervention should be based on a clearly identifiable and significant market failure.

VI. Postscript

While we view the Competition Commission’s decision as a wel-

come check on the tendency of reg-ulators to acquire ever more intru-sive and discretionary powers, events subsequent to the publica-tion of the report show that regula-tors do not give up easily. It has recently become clear that Ofgem has abandoned imposing the MALC on electricity generators. Using its powers granted under the Electricity Act of 1989, Ofgem has proposed a modification to

est. The old habit of regulators seeking to extend their powers cer-tainly dies hard!

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Endnotes:

1.

The authors of this article represented AES in this inquiry.

2.

United Kingdom Competition Com-mission,

AES and British Energy: A Report on References Made under Section 12 of the Electricity Act 1989

, Dec. 2000.

3.

See, for example, John Vickers and George Yarrow,

The British Electricity Exper-iment

, 12

Econ. Policy

, 1991, at 188–232; and John E. Kwoka, Jr.,

Transforming Power: Lessons from British Electricity Restructuring

,

Regulation

, 20(3) 1997.

4.

For example, in his submission to the Competition Commission, Professor Richard Green stated that these changes in ownership structure reduced the potential for abuse by approximately half.

Supra

note 2, paragraph 7.283.

5.

Supra

note 2, paragraph 2.74.

6.

Ofgem,

Introduction of a “Market Abuse” Condition into the Licences of Cer-tain Generators: Ofgem’s Initial Submission to the Competition Commission

, May 2000.

7.

Supra

note 6, paragraph 4.28.

8.

It is, of course, more complex to define the with- and without-merger scenarios in fast-moving industries, as the Euro-pean Commission has found in a number of cases, for example, in the telecommunications/media sectors.

9.

Supra

note 2, paragraph 2.187.

10.

Id

., paragraph 2.189.

11.

Id

., paragraph 2.197.

12.

Id

., paragraph 2.258.

13.

U.K. Department of Trade and Indus-try,

Second Consultation on Proposed Modi-fications to Licence Conditions

, Aug. 14, 2001.

generation licenses that is almost identical to the MALC.

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The new condition contains two of the three examples of offending behavior given under the MALC and also gives Ofgem wide-ranging powers to identify and control “detrimen-tal” behavior. Despite the earlier rejection of the MALC by the Com-mission, this new license modifica-tion is supported by the U.K. government. In effect, Ofgem is cherry-picking its way through legislation to achieve ends that an independent appeals body has ruled to be against the public inter-

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