Collections series 1

THE DEVELOPMENT OF ENERGY REGULATION

~ A COLLECTION OF REVIEWS

Chris Bolt Douglas McIldoonCarl Danner Stephen LittlechildTim Davis Tanga McDanielLin Fitzgerald David NewberyDavid Green Gill OwenRichard Green Graham ShuttleworthLeigh Hancher Stephen Trotter Catherine Waddams Price

The University of Bath School of Management

is one of the oldest established management schools in Britain.

It enjoys an international reputation for the quality of its teaching

and research. Its mission is to offer a balanced portfolio of

undergraduate, postgraduate and post-experience programmes,

research and external activities, which provide a quality of

intellectual life for those involved in keeping with the best

traditions of British universities.

THE DEVELOPMENT OF ENERGY REGULATION

~ A COLLECTION OF REVIEWS ~

COLLECTIONS SERIES 1

Editor Peter Vass

Director, CRI University of Bath

School of Management

Compiled by Jan Marchant

The University of Bath All rights reserved ISBN 1 85790 117 7

Centre for the study of Regulated Industries (CRI) The CRI is a research centre of the University of Bath School of Management. The CRI was founded in 1991 as part of the Chartered Institute of Public Finance and Accountancy (CIPFA). It transferred to the University of Bath School of Management in 1998. It is situated on the 8th floor of Wessex House (North), adjacent to car park H. The CRI is an interdisciplinary research centre investigating how regulation and competition are working in practice, both in the UK and abroad. It is independent and politically neutral. It aims to produce authoritative, practical contributions to regulatory policy and debate, which are put into the public domain. The CRI focuses on comparative analyses across the regulated industries. CRI activities and outputs include:

Regulatory statistics, information and analysis Discussion papers and Occasional papers Regulatory Briefs, Reviews and International series Research Reports and Technical papers Seminars, courses and conferences

Direct links with regulated industries, the regulators, the academic community and other interested parties are an important feature of the work of the CRI. The CRI is non-profit making. Its activities are supported by a wide range of sponsors. BAA CIPFA Department of Trade and Industry Environment Agency National Audit Office NERA National Grid Transco

Network Rail OFWAT RSM Robson Rhodes Royal Mail Thames Water United Utilities Wessex Water

Further information about the work of the CRI can be obtained from:- Peter Vass, Director-CRI, School of Management, University of Bath, Bath, BA2 7AY or CRI Administrator, Jan Marchant, Tel: 01225 383197, Fax: 01225 383221, e-mail: mnsjsm@management.bath.ac.uk and from the CRIs web site, which includes events and the publications list. http://www.bath.ac.uk/cri/ Publications and publications list can be obtained from Jan Marchant as above.

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PREFACE The CRI is pleased to publish its first collection of reviews, drawn from the last three Regulatory Reviews. The purpose of the collections series is to bring together a set of contributions which focus on a particular sector or theme, given each Regulatory Review focuses on comparative analysis at a period in time. This has arisen, in part, because bringing together contributions from successive Regulatory Reviews can provide insights, for example, into the development of regulation, but also because we often get requests from readers to the effect that it would be useful if we could bring together the material on, for example, energy.

Energy is the topic we have chosen for the first in the collections series, with contributions drawn from the successive biennial Regulatory Reviews for 1998/1999, 2000/2001 and 2002/2003. The first two sections cover the historical evolution of regulation for electricity and gas respectively, and the third covers a selection of energy themes: social, economic and international experience. The contributions are reproduced as they were published in their respective Regulatory Reviews, except for some presentational changes to achieve a common format. Revisions would have defeated the purpose of the historical perspective. We would be pleased to receive any comments readers might have as to the usefulness, or development, of the CRI collections series.

The CRI publishes a wide range of occasional and technical papers, research reports and regulatory briefs, and encourages those working in the field whether as academics or in other organisations to submit suitable material for consideration for publication. Enquiries and manuscripts should be addressed to: CRI, School of Management, University of Bath, BA2 7AY.

Peter Vass Director, CRI May 2003

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CONTENTS

Preface iiiElectricity regulation

1 Graham Shuttleworth Regulatory Review 1998/1999: chapter 2

1

2 Stephen Littlechild Regulatory Review 2000/2001: chapter 2

17

3 Richard Green and Stephen Trotter Regulatory Review 2002/2003: chapter 2

55

Gas regulation

4 David Green Regulatory Review 1998/1999: chapter 3

89

5 Lin Fitzgerald and Catherine Waddams Price Regulatory Review 2000/2001: chapter 3

99

6 Chris Bolt and Tim Davis Regulatory Review 2002/2003: chapter 3

111

Energy themes

7 The Role of Social Policy in Energy Regulation Gill Owen Regulatory Review 2000/2001: chapter 16

127

8 Liberalised by Brussels: Cross-border Electricity Markets in Ireland Douglas McIldoon Regulatory Review 2000/2001: chapter18

137

9 Auctions and Trading in Energy Markets an Economic Analysis David Newbery and Tanga McDaniel Regulatory Review 2002/2003: chapter 10

153

10 Enduring Lessons of Californias Electricity Crisis Carl Danner Regulatory Review 2002/2003: chapter 11

193

11 Revising the European Communitys Internal Energy Market Leigh Hancher Regulatory Review 2002/2003: chapter 12

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Acknowledgement This chapter was first published as The Electricity Industry 1997-98, CRI Regulatory Review 1998/9, chapter 2, pp19-33, January 1999, University of Bath. Graham Shuttleworth, Director, National Economics Research Associates

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1 THE ELECTRICITY INDUSTRY 1997-98 Graham Shuttleworth Introduction For some time now 1998 has symbolised the dawn of a new competitive era in the electricity industry. When the industry was reformed in 1990, it was agreed that eight years would be sufficient time to clear some outstanding commitments. Expensive, old-fashioned power stations would be amortised or closed down, and uneconomic coal production would be phased out. It was expected that the industry would itself to the public in April 1998 as a set of lean and competitive companies. At that time, all consumers would be granted the right to choose who sold them electricity, ending a century or so of monopoly. The plan to end monopoly franchises over electricity supply must have appeared to some as a technicality, the mere abolition of a legal restriction on electricity companies.1 In 1994, however, the partial reduction in the franchise (limiting it to customers with peak loads below 100 kW) illustrated the scale of the exercise required to incorporate even a fraction of the

1 Within the UK electricity industry, the word supply is used to denote the function of selling electricity to final consumers. In other systems, this is known as retailing or commercialisation. It is distinct from the business of distributing electricity over low voltage wires, and may be performed by a different company.

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nations consumers into the electricity market. This apparently minor reform caused so many difficulties that the industry immediately began to prepare for the ultimate reform, which soon came to be denoted 1998. Since then, the cost and effort of preparing for 1998 has sometimes appeared to crowd out other initiatives. However, while 1998 has inexorably come (and almost gone), expectations of a year of competition have not been fulfilled. The costs have escalated (although not beyond the bounds predicted by the industry) and the reforms have been delayed. Retail competition in electricity will now be fully implemented only in 1999. At the same time, other concerns have absorbed more and more of the industrys attention, so that 1998 may well be remembered more for developments in regulation, than for the expansion of competition. European background In Europe, work continued on implementing the EU Directive on the Internal Electricity Market. Increasingly, proposals in other countries are beginning to adopt features found in the UK. The German industry developed a distance-related transmission tariff; the French government has shown itself to be very interested in regulated third party access; and an electricity pool similar to that found in the UK began operation in Spain in January 1998. All countries are racing to implement the directive by January 1999 and one might have expected the UK to lead to way to full competition.2 In fact, the UKs progress has been dogged by delay. Expansion of supply competition

2 Belgium, Ireland and Greece have deadlines which are one or two years later, to allow for a more gradual transition.

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Opening the market to full competition - the final and most significant phase in bringing competitive supply to the electricity industry - was scheduled to commence in April 1998. However it became clear in January that difficulties in testing and fine-tuning the required IT systems would inevitably delay the start-date and Offer officially announced a postponement. Under the revised timetable, the first four PES markets (Eastern, Manweb, Yorkshire and Scottish Power) would only start to open for competition five months late, in September 1998. A further four PESs (MEB, Northern, Seeboard and Scottish Hydro) were to follow in October 1998, with the final six PES markets (East Midlands, London, Norweb, Southern, Swalec and Sweb) opening in December 1998. Competition will be introduced to each PES area in controlled phases, post-code by post-code, with the whole exercise being completed by June 1999. The year 1998 has therefore been one of unfulfilled promise in supply competition, although the prospects remain good for 1999. UK markets will still be more open than those in much of the EU. Government reviews The new Labour Government moved quickly to impose its windfall tax on the privatised utilities (as noted in the CRI Review of 1997), but the direction of longer-term policies affecting the electricity industry is taking longer to emerge. During 1997/98, the new ministerial team at the DTI, headed by Margaret Beckett, signalled its intention to reconsider a broad swathe of policy, with the announcement of major reviews of (1) energy sources for power generation, (2) electricity trading arrangements in England and Wales and (3) utility regulation in general. Despite a flurry of activity, it is not clear at the time of writing (September 1998) what new direction will emerge from these

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reviews in governmental or regulatory policy. The definition of government policy is likely to be delayed by Peter Mandelsons replacement of Margaret Beckett at the helm of the DTI, in the Cabinet reshuffle of July 1998. The publication of the governments conclusions on utility regulation, right at the end of Margaret Becketts tenure, does offer the prospect of a more transparent, more consistent, and more predictable regulatory process, as we discuss below. However, the impact of the utility regulation review will depend heavily on individual regulators for its implementation, and may be overshadowed by government interventions. We therefore review the government policy reviews, before turning to the utility regulation review. The fuel sources review On 3 December 1997, Minister for Science, Energy and Industry John Battle announced a review of the role of security of supply and fuel diversity in the award of government consent for new power stations.3 At that time, the minister emphasised the need for security of supply: could a system that is increasingly dependent on gas-fired generating capacity be trusted to keep the lights on? Concerns about the security of gas-fired generation led the minister to announce a moratorium on new consents for gas-fired power station, to halt the much discussed dash for gas while the review took place. On 10 December 1997, the Prime Minister announced that the scope of the review would be wider than gas. The terms of reference issued on 22 December 1997 by Margaret Beckett, Secretary of State for Trade and Industry, announced a review of all fuel sources used in generation, with particular reference to the role of coal.

3 In addition to the planning regulations, Section 36 of the Electricity Act of 1989 requires generators to seek government consent for the construction, expansion or operation of power stations. Section 14 of the Energy Act 1976 gives government the power to block proposals to burn gas in power stations. The Secretary of State has threatened to exercise both powers in order to halt the construction of gas-fired power stations.

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The original security of supply basis of the review has been called into question by many observers. Even the House of Commons Trade and Industry Select Committee concluded in its June 1998 energy policy report that there are no reasons on grounds of security of supply, or in terms of confidence in long-term availability, to resist the growing use of gas.4 Given the difficulty of establishing any cause for concern over security supply, the review has come to focus increasingly on the prospect that deep mining of British coal might come to an end in the immediate future. In 1990, support to the British coal mining industry was one of those outstanding commitments that the electricity industry was able to fulfil, so long as the retention of retail monopolies allowed any excess costs to be passed through to consumers. British Coal, the major generators and the PESs were able to negotiate further 5-year coal and electricity contracts in 1993, albeit at lower levels of production and only after some encouragement from the DTI. Once again, these agreements relied on the PESs ability to pass through the additional costs to consumers. The threatened abolition of retail monopolies in 1998 (or thereabouts) removed the ability of electricity companies to take on such uncompetitive commitments. Subtle pressure from politicians no longer had its desired effect on an increasingly fractious industry. The government published the preliminary conclusions of this review in June 1998.5 Beforehand, paymaster-general Geoffrey Robinson had made frantic efforts to broker a coal deal behind the scenes. However, perhaps surprisingly, the government

4 House of Commons Trade and Industry Committee, 5th Report 1997-98, Vol 1 (HC 471-i), Energy Policy, paragraph 42, page xxvi. 5 DTI, Review of Energy Sources for Power Generation: Consultation Document, 25 June 1998.

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chose not to propose long-term contracts with generators as the means to secure continued use of British coal, the tactic adopted by the previous Conservative administration in 1990 and 1993. The imminent removal of the franchise supply market, which had been used to subsidise British coal in the past, now makes such intervention far more difficult. The government did not, in fact, argue a special case for coal at all. Instead, it blamed structural distortions within the UK electricity market for exacerbating coal's plight. Accordingly, the government appeared to believe that proposals for reform of electricity trading would secure a future for British coal, by restoring a level playing field. In Chapter 4 of its preliminary conclusions, the DTI described the role of the pools trading arrangements in distorting the choice of energy sources for power generation, but the analysis is not compelling. Specifically, the government repeated the argument made by various parties, that the current method of setting a single system marginal price for all electricity sales unduly favours the gas-fired and nuclear baseload generators. This method allows baseload generators to offer zero prices, in order to guarantee their despatch, because they know they will receive the pool price regardless. This approach to bidding is felt to disadvantage coal-fired generators, which operate normally with mid-merit (ie, higher) variable costs. Unfortunately, the government failed to show exactly why the pricing method harmed coal, why coal stations could not secure their output by following exactly the same approach as gas-fired stations, or how matters would be improved by adopting a different pricing method. Several commentators have pointed out that changing the pricing method will not alter the efficient pattern of plant construction or despatch. The incentive to build gas-fired generation (in particular) depends on the overall level of prices, whilst the incentive to run gas-fired generation depends on the form of their gas contracts; reforming pricing rules of the electricity market is unlikely to change either of

GRAHAM SHUTTLEWORTH

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these factors. Both the DTI and Offer have hinted the pool prices are 10% higher than necessary, but neither has really shown how reform of pool pricing rules would lower prices.6 7 Despite the question marks hanging over the analysis, the government is now relying on the possibility (1) that significant reforms will emerge from the review of electricity trading arrangements (see below), and (2) that these reforms will bolster demand for coal-fired generation. At the same time, Offer and the government are advocating further divestment of coal-fired plant by National Power and PowerGen, to curtail their market power, to reduce spot prices and hence to eliminate uneconomic incentives for construction of gas-fired generation. If implemented, this divestment may have a large impact on prices and investment, regardless of any reforms to the pool. However, until the perceived distortions are removed, the government intends to maintain a presumption that new gas-fired stations will normally be inconsistent with the government's diversity and security of supply concerns. In practical terms, the government has imposed a moratorium on issuing consents for new gas-fired power stations (although there are exceptions to this moratorium, in particular for highly efficient combined heat and power plants). While the moratorium on new plant remains, entry into the market will be restricted and, all other things being equal, one might expect spot prices to be higher. As a result, the full potential for competition in the electricity industry is unlikely to be realised in the near future.

6 The DTIs Press Release of 25 June 1998 refers to a suggestion in the DGESs submission to the Energy Sources Review. 7 Offers submission to Energy Sources Review suggests that pool prices are currently 10% above the cost of a Combined Cycle Gas Turbine (p33).

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The DTI/Offer review of electricity trading arrangements In October 1997, the DTI announced a review of the electricity trading arrangements and their governance in England and Wales. In doing so, the Secretary of State was responding to long-standing and often vociferous criticism of the current pool. Complaints have taken one of three basic forms: pool prices are too high; the pool rules are too complicated; and/or the pool organisation does not respond to change. The review of electricity trading arrangements offered a chance for all these complaints to be given a hearing. The secretary of state handed responsibility for the review to the director general of electricity supply. Offer embarked on an extensive consultation process, culminating in the publication of final proposals in July 1998.8 As of September 1998, however, the industry is still awaiting the response of the secretary of state. Offers proposals signal a desire for a significant shift away from the current system of mandatory centralised trading of electricity (via the pool), with more emphasis being placed on voluntary bilateral trading (between traders or brokers). Since bilateral contracts are already permitted, the proposals focus on the timescales for trading, and extend the scope of bilateral trading closer to real time. Under Offers proposals, electricity will be traded in three distinct market phases. 1. Forward contracts markets will be free to open as and when

required, allowing bilateral trade ahead of time at prices negotiated between individual traders and brokers.

2. A centrally organised screen-based bilateral exchange will

also operate from 24 hours to around four hours ahead of

8 Offer, Electricity Trading Arrangements: Proposals, July 1998.

GRAHAM SHUTTLEWORTH

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delivery. In this market, transactions will also be executed at privately determined prices.

3. At a certain point (provisionally estimated as four hours in

advance of delivery), a balancing market will open to reconcile traders current positions with the actual pattern of generation and demand.

In the balancing market, the system operator would act as counter-party to all trades; a market operator would settle the financial liabilities associated with balancing market trades, and with any remaining imbalances (ie, the differences between traded volumes and actual flows over the network). The pricing rule for this balancing market would, said Offer, be most likely based on the pay-as-bid style of auction, where trades are conducted at the prices stated in each offer or bid, rather than at a market-clearing system marginal price. In practice, this proposal is less radical than it might appear, since the pool settles short-term balancing trades on precisely this basis at present. Under the current rules, before each trading day begins, the pool matches offers to generate from individual generators with a demand forecast produced the National Grid Company. This matching process culminates in the calculation of a single pool purchase price, which is paid to all generators whose offers have been accepted (the pool purchase price is related to, but not actually identical with, the system marginal price which attracted so much criticism). The role for consumers to participate in the market is limited; a scheme to reward interruptible customers has also been heavily criticised for offering participants non-economic payments. Offers proposals anticipate that this reliance on demand forecasts will be replaced by full participation of customers in the market. Offer recognises that many aspects of its proposals have yet to be resolved. The pricing rules for imbalances and the treatment of transmission constraints require detailed examination. In its

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Interim Conclusions of June 1998, Offer suggested that such problems were minor and had been largely solved in the UK gas market.9 The proposals are, however, more circumspect.10 Offer now proposes the creation of a development and implementation steering group to investigate further many aspects of the proposal. The existing arrangements set the crucial pool purchase price a day in advance, by matching offers to supply against a demand forecast; this price applies to all day-ahead sales. The proposed reforms are intended to encourage power trading closer to real-time, to allow a greater role for bidding by consumers in trading and setting prices, and (probably) to place more reliance on the pay-as-bid style of trading, instead of auctions with a single market-clearing price (system marginal pricing). How these ideas will be put into practice has yet to be determined. With regard to reform of pool governance, Offers proposals focus on oversight of the balancing market. Participation in the balancing market (directly or via a broker) will be compulsory for anyone trading over the network, to ensure that trades are reconciled with all power flows. Offer had originally suggested that balancing market operations should be governed through the system operator (NGC), allowing Offer to exercise control in turn via NGC's transmission licence. However, in response to industry concerns over possible conflicts of interest, it is now proposed that a balancing and settlement code panel, drawn from all interest groups, should oversee the electricity trading arrangements.

9 Offer, Review of Electricity Trading Arrangements: Interim Conclusions, June 1998. 10 On 16 September, the Financial Times reported that Ofgas was about to investigate problems with bilateral trades in the gas market. The problems arose when a transmission constraint affected capacity at the St Fergus terminal. This incident suggests that reference to the gas market does not provide ready-made solutions.

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Offer conducted the review through an extensive sequence of consultation papers and explanatory seminars, as well as smaller meetings with interested parties. The proposals break new ground (for Offer, at least) in the extent to which they report the views contained in submissions. The pools own role in the DTI/Offer review took on a novel form as well. Having been criticised for failing to respond to consumers concerns, the pool drew on all sections of the electricity industry (including non-pool members) to establish a pool review steering group (PRSG). This PRSG managed the pools input into the DTI/Offer review, which was intended largely to ensure objective and consistent appraisal of reform proposals. To ensure that its advice was as broadly based as possible, the PRSG first established a set of widely accepted objectives for the trading arrangement.11 On the basis of these objectives, the PRSG developed a performance framework for appraising alternative reform proposals.12 The value of this framework has been widely acknowledged by participants in the review, including Offer. This work gave the pool, in particular, a higher profile and a more widely accepted role than might have been anticipated in a government review of the pools own procedures. Despite the use of public consultation, many participants expressed disappointment with Offers conduct of the review process and with the quality of the debate (though most commented sotto voce, so as not to appear too negative). Indeed, it is difficult to find any rigorous analysis to underpin the reform proposals. Offers seminars (each holding up to 250 people) allowed many unsupported assertions and occasional bouts of rhetoric to proceed unchallenged. There remain significant omissions from Offer's proposals, notably regarding

11 Pool Review Steering Group, Objectives for the Electricity Trading Arrangements, Final Report, 6 April 1998. 12 Pool Review Steering Group, A Performance Framework for Evaluating Electricity Trading Arrangements.

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the prices for balancing market trades and imbalances, and the treatment of transmission constraints. Given these deficiencies in the process, it must be difficult for anyone to assess the reliability of Offers conclusions. The Secretary of State is certainly taking his time to respond, as the DTI tries to form its own opinion of the proposals. Such doubts over the review process must only serve to reinforce the DTIs determination to reform utility regulation. The review of utility regulation The DTI review of utility regulation was initiated in June 1997. Following consultation on a green paper issued in March, the governments conclusions were published in July 1998.13 14 These conclusions support the continued use of RPI-X price caps as the fundamental system of price regulation. However, they also suggest several reforms which are intended to give more emphasis to consumers interests and to promote more transparent, stable and predictable regulation. In reaching these conclusions, the government is undoubtedly responding to trenchant criticism of the current regulatory systems. First, the government has signalled its intention to harmonise the regulatory regimes in the gas and electricity industries. Harmonisation would begin with the unification of electricity and gas regulatory offices under a single energy sector regulator. This stage will happen by default at the end of 1998, when the newly appointed director general of gas supply takes over the equivalent position for electricity. However, further legislation

13 Department of Trade and Industry, A Fair Deal for Consumers: Modernising the Framework for Utility Regulation, CM3898, March 1998. 14 Department of Trade and Industry, A Fair Deal for Consumers: Modernising the Framework for Utility Regulation - The Response to Consultation, July 1998.

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may be required to bring the powers of the two director generals into line (in order to clarify which powers and duties apply to the joint regulator at any time). The situation in Great Britain will then parallel that in Northern Ireland, where Ofreg has always had responsibility for both electricity and gas. Second, new legislation would bring the two legal frameworks closer into line:

1. The current licence for public electricity supply will be split into separate licences for supply and public electricity distribution (as has already occurred in gas);

2. In the context of reform of the electricity trading

arrangements, the government will consider granting new powers over the pool to the director general of electricity supply;

3. The government has indicated that it will consider legislation

to ensure that gas and electricity network charges favour pre-payment customers, unless the on-going process of competitive market reform yields a fair share of the benefits of liberalisation to disadvantaged customers.

Third, and most radically, the review stresses the importance of ensuring that regulators decision-making processes and regulatory methodology are clear, predictable and widely understood. To support a more open system of regulation, the government will require regulators to give reasons for key decisions, and to consult on and institute a code of practice governing consultation and decision-making procedures. These requirements would cover procedures for determining when a market has moved from a pre-competitive to a fully competitive state, which will be particularly important for the development of competition in retail supply of electricity. In future, the government will itself issue guidance to regulators on social and environmental

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objectives through transparent statutory means, rather than the informal nods and winks which serve as policy guidance at present. Implementation of these proposals would change the basis for regulatory debate in the UK, by making it more difficult for regulators to avoid evidence, or to avoid taking it into account. The discretion of individual regulators will be further limited by the appointment of three member executive boards, although how the executives will interact has not been spelled out in detail. No doubt they will consult one another, but the DTI seems to envisage that each executive would have separately defined responsibilities. If taken literally, this separation of responsibilities seems to be a recipe for a continuation of personalised (ie, unstable) regulation, without the benefit of co-ordination across the whole range of activities. Surely, one must hope for some other more co-ordinated practice to evolve. The DTI places responsibility on the individual regulators for introducing the new procedures. Nevertheless, the DTIs commitment to a more transparent and consistent process of regulation is potentially very significant for the electricity industry. Offer has been relatively slow to adopt formal regulatory procedures and is only beginning to provide detailed (if still incomplete and uncompelling) explanations of its regulatory decisions. For these reasons, regulated companies have found it relatively difficult to challenge Offers decisions (the lack of challenge should not, of course, be taken as evidence of good decisions, but of opaque decision-making procedures). In June 1998, the ability of utilities to challenge their regulators was further curtailed by the judicial review of Ofregs decision on transmission and distribution charges for Northern Ireland Electricity (NIE). NIE had disagreed with Ofregs decision and the dispute had been referred to the Monopolies and Mergers Commission (MMC). The MMC produced a different result, more in NIEs favour, but Ofreg chose to ignore it. On judicial

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review, the high court decided that Ofreg was not compelled to follow the advice of the MMC, an outcome which rather undermines the basis for appeal within UK regulation. However, in future, regulators will clearly have to meet some minimum standards in their procedures. If they do not, they will be open to stiff criticism from both regulated utilities (who do not often benefit from opaque decision-making) and consumers (who also want to know the basis for the prices they pay). If the DTI can open up new grounds and new avenues for challenging regulators decisions, it will undoubtedly shift the balance of debate in regulation and demand more reasoned decisions from all regulatory agencies. Conclusion An observer looking ahead a year ago to the prospects for 1998 might reasonably have hailed it as the Year of Competition in the electricity industry. In this respect, 1997/98 has been a disappointment: introduction of the final phase of supply competition has been delayed; the government moratorium on new gas-fired generating capacity has restricted competitive entry into the generating market; and the ability of power trading reforms to enhance competition has yet to be demonstrated. Instead, 1997/98 has been a notable year of regulation in the electricity industry. Merger of the gas and electricity regulators has been mooted; the scope of regulatory involvement within revised trading arrangements is likely to expand; and, most significantly, the governments proposals on utility regulation promise greater transparency and stability in the regulatory process. Taking on board the DTIs recommendations for utility regulation could cause a fundamental shift in the way that regulators and regulated companies relate to one another. In the

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end, this might be the most significant contribution to consumer welfare of all the government reviews carried out in 1997/98.

Acknowledgement This chapter was first published as Electricity Regulation, CRI Regulatory Review 2000/2001, Millennium edition, chapter 2, pp25-62, February 2001, University of Bath. Stephen Littlechild, Honorary Professor, University of Birmingham Business School and Principal Research Fellow, Judge Institute of Management Studies, University of Cambridge

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2 ELECTRICITY REGULATION

Stephen Littlechild Introduction I prepared for this review by reading the previous CRI electricity reviews dating back to 1992. Several points struck me forcibly. First, the high quality and readability of the papers, where the highlights of the year were brought to life without neglecting duly to record the more mundane things done. The authors comments and predictions, sometimes delicate, sometimes vigorous but always welcome, shed as much light on the authors own preoccupations as on the actions of the parties under review. Second, the broadly constant nature of the issues over the years. Promoting competition in generation and supply, regulating monopoly in transmission and distribution, the accountability of the regulator, the role of government: all these appeared every year, always with some new aspect. Some themes, like prices and profits, dominated the early years then faded somewhat;

I am grateful for comments and suggestions from Dr Eileen Marshall of Ofgem and from the editor Peter Vass. Responsibility for any remaining errors is mine. Also published as Department of Applied Economics (DAE) Working Paper No 0026, University of Cambridge, 24 November 2000.

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other topics, like the capital markets and industry restructuring, gradually came into greater prominence; yet others, like quality of supply, the environment and energy efficiency, made sporadic appearances but were never absent for long. Third, how often the author exclaimed, in effect, another momentous year. Regulation has not faded away, it has flourished. It has not merely coped with change, it has just as often instigated it. In every year there has been something new and exciting. Never a dull moment. And so it has been in the period under review. Actually over two years this time, roughly from September 1998 to December 2000. But this time with one significant change, at least for me. I am now the reviewer, no longer the object under review (except for the last few months of 1998). I can hardly claim to be objective in this matter, and certainly I feel a great deal of sympathy for my successor as director general, Callum McCarthy, and the new regulatory office Ofgem.1 I think I understand the kinds of situations in which they found themselves, and the pressures and opportunities they faced. And on the whole, I must say, I have a great deal of admiration for how the regulator has acquitted himself. 1998 and supply competition Graham Shuttleworth opened last years CRI review (Regulatory Review 1998/99) with the following sentence, For some time now 1998 has symbolised the dawn of a new competitive era in the electricity industry. When the industry was privatised, it was agreed that all customers would have the right to choose

1 Callum McCarthy took over as director general of electricity supply on 1 January 1999, having been appointed director general of gas supply a couple of months earlier. The former regulatory offices, Ofgas and Offer, were renamed the Office of Gas and Electricity Markets (Ofgem) on 16 June 1999. The Utilities Act 2000 that formally merged the two statutory functions is discussed in the text below.

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their own retail supplier, with the market opening in three phases: 1990, 1994 and 1998. Shuttleworth went on to say that 1998 had come and almost gone, the expectations of a year of competition had not been fulfilled, the costs had escalated, the reforms had been delayed and retail competition in electricity will now be fully implemented only in 1999. It is only right to begin, then, by confirming that retail competition was fully implemented in 1999. The market for customers with maximum demand above 100kW, accounting for about a half of the total demand, had of course been opened long before. The opening of the market for under-100kW customers was phased in between September 1998 and June 1999 according to the revised timetable established early in 1998. And on the whole all went smoothly and according to plan. Nearly a quarter of this market was open by the end of 1998, three-quarters was open by March 1999, and the whole market was open by 24 May 1999, a month earlier than planned.2 Much of the credit for this must go to Tony Boorman, the director in charge at Offer and later Ofgem, who oversaw, guided and indeed drove the whole process. But the industry as a whole worked hard to achieve the target, and PA consultants deservedly received the annual award of the Management Consultants Association for their contribution to the project management. Awareness of competition was high. A MORI sample survey showed that, as early as February 1999, 89% of customers in areas then open to competition were aware that they could buy electricity from other suppliers.3 And shop around they did, on a

2 A Review of the Development of Competition in the Designated Electricity Market, Offer/Ofgas, June 1999. Unless otherwise indicated, all the references in this chapter are to Ofgem publications. They are available on the Ofgem website www.ofgem.gov.uk. 3 Electricity Competition Review: February/March 1999, research study conducted by MORI for Offer, June 1999. By October 1999 the awareness figure had increased to 95% nationally. (Electricity and Gas Competition Review, a research study conducted for Ofgem by MORI, January 2000).

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remarkable scale. By the end of May 1999, suppliers other than the local PES supplied some 1.3m customers, nearly 5% of the total. Subsequently, customers transferred at a rate that has averaged nearly 100,000 per week over the last eight months. By the end of September 2000 over 20% of domestic customers had registered to change supplier. There have admittedly been some difficulties over this period. Most important, despite a considered and focused set of regulatory obligations and guidelines, there have been numerous concerns and complaints about the marketing tactics of certain companies, principally associated with doorstep selling.4 The number of complaints against public electricity suppliers (PESs) received by Offer and the electricity consumer committees fell from 6320 in 1997/98 to 6152 in 1998/99. However, within that, Northern Electrics complaints increased from 418 to 1447 over the same period. Ofgem attributed this to problems in the companys handling of dual fuel complaints and in the introduction of a new computer billing system. In addition, there were for the first time 1230 complaints about second tier suppliers in 1998/99. The picture in 1999/2000 was worse. Complaints against PESs increased by 40% to 8610, within which they more than doubled for three companies. And complaints against second tier suppliers increased nearly twenty-fold to 22,507.5 In mitigation a number of points might be made. The problem was somewhat localised, associated mainly with three PESs within their areas and with two companies (British Gas and

4 The extent to which suppliers are relying on estimated meter readings at change of supplier has also been a cause of concern. In addition, Ofgem has claimed that some incumbent public electricity suppliers (PESs) have been unreasonably blocking the ability to move of some customers, such as those in debt, and it has been concerned to remove or reduce barriers to competition for disadvantaged customers. 5 Reports on Services for Electricity Customers 1998/99, (October 1999); 1999/2000, (October 2000). Also Electricity Complaints Statistics 1, January to 31 August 2000, (12 October 2000).

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Independent Energy) selling second tier. The total complaint rate was small in relative terms: even 22,000 second tier complaints represent a complaint rate of less than one per one thousand customers. The total number of complaints seems to have decreased slightly from the peak in January to March 2000. Companies began to discipline their selling agents and explore alternative ways to win customers, for example by tele-marketing. Moreover, experience in the gas industry suggests that doorstep selling provided access to low income customers that would not otherwise have been aware of the opportunities, and customer surveys indicated that most people found such experience to be acceptable.6 Ofgem required Independent Energy to cease accepting new domestic and small business customers, and Northern Electric to limit its new acceptances, until their performance improved. Independent Energy, the most aggressive and apparently successful new entrant, not only experienced significantly higher complaints than other companies about direct selling, erroneous transfers and customer billing, it also failed to bill and collect the revenues it was due. It announced on 8 September 2000 that it was in receivership, and on 14 September the receiver announced that its major supply business assets had been sold to Innogy, the domestic successor company to National Power. In contrast, Ofgem announced on 20 November 2000 that Northern Electric had made good progress towards dealing with its problems, its complaints had fallen substantially, and its undertaking to limit the take-up of new customers was lifted. Some difficulties were to be expected given the enormous scale and pioneering nature of the policy of opening the domestic market to competition. They have annoyed customers, but they should be transitional rather than permanent problems.

6 A Review of Competition in the Designated Electricity Market, Offer/Ofgas, June 1999, pp41-2; Marketing Gas and Electricity, A Consultation Document, January 2000, pp6-13. Also MORI surveys referenced above.

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Price reductions and supply price controls What sort of price reductions have been available in the competitive market? Offers June 1999 review showed best available savings averaging about 10% for standard quarterly payment customers, and about 6% for prepayment. These were savings compared to the PES charges, which in turn were broadly at the maximum levels allowed in the transitional price caps set in early 1998 for the two years to March 2000. The question then arose: should these transitional price caps be continued after March 2000? After all, supply price controls had been discontinued for large and medium-sized customers when they first had access to competition. Ofgem took the view that the price caps could be removed for small business customers but should be maintained for a further two years for domestic customers, since competition had not yet developed sufficiently to protect the interests of all domestic customers.7 The key factors in this distinction between customer classes seemed to be the percentage of customers switching and the size of the price reductions offered. Initially Ofgem proposed to tighten the caps by about 10% for standard quarterly payment customers. This was to reflect recent falls in generation charges and the prospectively lower distribution charges following the distribution price control review (see below). My own concern was that such tightening might be excessive.8 The publicised best savings rather overstated the extent of price reductions available and taken up. They depended unduly on a few suppliers (one of which later went out of business, as noted above). A better measure was the upper quartile price reduction

7 Reviews of Public Electricity Suppliers 1998 to 2000, Supply Price Control Review: Initial Proposals, October 1999. 8 Stephen Littlechild, A Competitive Shock to the System, Financial Times, 11 November 1999, p21, and Promoting Competition in Electricity Supply, Power UK, Issue 68, 29 November 1999 pp12-19.

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available in each area.9 These reductions were under 6% for standard quarterly payment customers and about 1% for prepayment customers (compared to the best savings of 10% and 6% mentioned earlier). In my view, tightening the price caps to the extent proposed might have short-term benefits to customers at the expense of companies, but there would be longer-term disadvantages in terms of reduced competition, choice and innovation. Such tightening would seriously weaken the ability of competitors to compete in terms of better prices, and would reduce the incentive of customers to switch. A policy of using price controls to convey the benefits of a competitive market to all customers could soon result in the disappearance of those competitors. It would also make it difficult ever to remove the control, since it would reduce both the proportion of customers switching and the extent of price reductions offered, and these (as just noted) seemed to be Ofgems criteria for removal of the controls. I suggested tightening only the least severe price caps in order to align the caps more consistently with each other. This would have led to an average reduction of about 2% for quarterly payment customers. Ofgem considered this argument along with other representations. It eventually proposed tightening the caps for standard quarterly payment customers by about 6%, rather than the 10% proposed earlier.10 The average upper quartile savings that competitors are now offering to quarterly credit customers seem to be broadly similar to those available before the price cap revision. In terms of customers transferring to other suppliers, the momentum of competition has been maintained. The prospects for removing the supply price control for most residential customers are therefore good, and Ofgem has recently reaffirmed its intention

9 Calculated by ranking the percentage price reductions of all suppliers in the area, and taking the level such that one quarter of the suppliers offered that reduction or better. 10 Review of Public Electricity suppliers 1998 to 2000, Supply Price Control Review: Final Proposals, December 1999.

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to do this in April 2002.11 But why wait? A fifth of domestic customers have now changed supplier, and if the present rate of transfer continues, over one third of them will have done so by the middle of next year. Retail supply competition is evidently working. Is there not a good case for removing the price caps now, at least for quarterly credit and direct debit customers? A difficulty must be acknowledged with respect to prepayment customers. The levels of these price caps are so tight that the average upper quartile savings that competitors are offering to such customers now seem to be negative. Only about 5 of such customers have changed supplier. The implication is that, in a competitive and uncapped market, the prices offered by incumbent suppliers could well increase to such customers, relative to those offered to other customers, in order adequately to reflect costs. Admittedly reductions in wholesale and other costs could offset this increase, at least in real terms. The price caps for supply to prepayment customers nevertheless need careful consideration, but this does not preclude removing the price caps for other customers. Distribution price control review The new director general took over just as the second review of the distribution price controls began. There was naturally interest in whether he would adopt the same methodology as had been applied five years before, and what the numbers would look like at the end. In the event, both the process and the methodology were broadly consistent with the previous approach, though there were

11 We shall in future, if all goes as we expect, not be continuing with any price control for supply businesses, once the present price controls for gas and electricity come to an end in April 2001 and 2002 respectively. Callum McCarthy, speech to MEUC, 8 September 2000. On 1 December he confirmed the proposal to remove the gas price control in April 2001.

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innovations in certain respects.12 With certain reservations, discussed below, Ofgem said that the RPI-X approach was justified by its achievements in reducing costs and improving quality of service. Ofgem also carried out a similar set of calculations to determine X. There was strong emphasis on standardising operating costs for differences in capitalisation, allocation and provisions. Ofgem assumed that companies with high standardised operating costs could move three-quarters of the way to the efficiency frontier represented by the two lowest-cost companies over the next couple of years. To give additional reward to efficient companies, the frontier itself was assumed not to move from the 1997/98 level. Capital expenditure was assumed to remain at about the same level as in the previous period, about 13% below the levels forecast by companies. The cost of capital (pre-tax WACC) was assumed to be 6.5%, down by half a percent from the previous review, principally to reflect a reduction over that period in the risk-free rate of return in the capital market as a whole. Faster depreciation was allowed (average life reduced from 33 to 20 years) to alleviate company finances now and to lower prices to customers later. I had previously scheduled the distribution review to run in parallel with the supply price review in order to make it possible, for the first time since privatisation, to look clearly at the allocation of costs between the two businesses. Ofgem also reviewed the arrangements for the separation of distribution and supply businesses. It concluded that meter reading should be transferred to supply and that there should be further separation of distribution and supply activities. On average Ofgem reallocated about 8% of distribution costs to the supply businesses. About half of these cost transfers related to meter reading and certain data processing functions.13 The transfer was

12 Review of Public Electricity Suppliers 1998 to 2000 Distribution Price Control Review: Final Proposals, December 1999. Deputy Director-General Richard Morse ably led the price control reviews. 13 The costs of meter assets remain with the distribution businesses.

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important in order to reflect the new division of activities between businesses and to avoid the monopoly distribution businesses anti-competitively cross-subsidising their own supply businesses, at the expense of distribution business customers and to the disadvantage of competing suppliers. Ofgems innovations in the calculation of allowed revenues included adjustments to reward those companies with the best past performance on quality of supply, customer complaints, capital efficiency, energy efficiency and accuracy of forecasts, and to penalise those with poorest performance. Typically these retrospective adjustments were of one quarter of a percent of allowed revenue in each case, with the total adjustments ranging between plus and minus 1.25%. There were also reductions in allowed revenue for companies involved in mergers and takeovers, in principle to share the benefits of economies of scale between shareholders and customers. Briefly, it was assumed that a merger would save about half the fixed costs of a distribution business, which would be around 20 to 25m a year. The control would be tightened by 12m five years after the merger, to allow time for the costs to be taken out and for some benefits to accrue to shareholders. The outcome of all this was an initial Po reduction in distribution charges, ranging from 19 to 33% for the England and Wales PESs, and averaging nearly 25%, plus a continued RPI-X control with X continued equal to 3. Remarkably, these reductions were of the same order of magnitude as those made in 1995 and 1996 (combined), after the previous price control review.14 At the time of that earlier review, no one would have believed possible a similar further reduction, just as no one at the time of privatisation would have believed the first reductions possible. It is a testament to the management and staff of the companies (and, I hope, to the regulatory regime) that the achieved and

14 Actually they were a little less this time because of the transfer of costs from distribution to supply, as discussed above.

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prospective increases in efficiency made it possible for all the companies to accept these proposals. The distribution price reductions were not achieved at the expense of quality of supply. As a result of the greater capital expenditure and better management, performance has improved over the past five years. For example, average minutes lost are now 50% less than before privatisation. As part of the distribution price control proposals, Ofgem proposed further modest improvements in average performance on availability and security for all distribution companies. Penalty payments for supply not restored within 24 hours were henceforth to be imposed for non-restoration after 18 hours. New standards for multiple and transient interruptions, and for telephone responses, were foreshadowed for April 2002. Ofgem later reviewed the National Grid Companys transmission price control. The director general commented favourably on the cost reductions achieved by NGC, which he attributed to the incentives provided by the RPI-X price control. The previous control had involved a Po reduction of 20% followed by RPI-4. Ofgem initially proposed a further Po reduction of between 6 and 12% followed by RPI-3 for the five years 2001 to 2006.15 The final proposals were rather different no Po reduction and RPI-1.5.16 This apparently reflected a number of factors: a couple of errors in the previous calculation, a larger capital expenditure programme than earlier envisaged, a less stringent projection of operating cost, and a cost of capital figure at the top end of the previously suggested range (the latter took note of a recent Competition Commission decision on the water industry price control).

15 The transmission price control review of the National Grid Company from 2001, Initial proposals document, June 2000. 16 The transmission price control review of the National Grid Company from 2001, Transmission asset owner - Final proposals, September 2000. A parallel document made initial proposals for NGCs System Operations Business.

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Future developments: the Information and Incentives Project The transmission outcome raises the question whether significant Po reductions can be expected in future revisions of the distribution network price controls. The scope for significant improvements and outperformance on operating costs is becoming more limited, and in any case the proportion of total cost accounted for by operating costs is reducing. The lower-valued initial vesting assets are now nearly depreciated and replaced by newer assets, valued at full cost, and there must be limited scope for further reductions in the cost of capital. The price control calculation is increasingly being dominated by capital expenditure, which has been rising steadily, and now averages over 50% higher than before privatisation. The trade-off between capital expenditure, quality and price will become increasingly critical. How is this best dealt with? In recent years, several of the companies, and others, have expressed concern about what they regard as increasingly intrusive regulation. A prime example would be an undue focus on inputs as opposed to outputs in dealing with capital expenditure. Ofgem acknowledged from the beginning the need to improve certain aspects of the price control process. It wanted to reduce the emphasis on periodic regulatory negotiations, to increase the emphasis on outperforming peers rather than gaming the regulator, to improve the balance of efficiency incentives as between operating and capital expenditure, to maintain a more continuous pressure for efficiency rather than encourage a deferral of cost reductions until just after each review, and to give clearer incentives to improve quality of supply. To this end Ofgem put in hand an Information and Incentives Project whose first task was to identify the key outputs that customers wanted and that companies could measure accurately

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and consistently. These were identified as the number and duration of interruptions, and the extent of customer satisfaction with company responses in the event of an interruption. The next stage is to improve company measurement of these outputs. The final step is to determine a set of rewards and penalties to incentivise the companies to deliver these outputs in future. For the initial period 2002-5 these will be limited to 2% of allowed revenue.17 It remains to be seen how this project develops. How far will thus specifying in advance the rewards and penalties for number and duration of interruptions make it possible for the regulator to leave the extent and nature of capital expenditure entirely to companies? Some companies are wondering whether the project will go far enough in incentivising company management to exercise judgement and economy, and to balance risk and reward. Some suggest that long lasting arrangements are needed, with agreed objectives, principles and procedures, subject to change only in extreme circumstances and via an agreed process.18 In this context, I am elsewhere considering the nature and experience of long-term contracts in the commercial sector. A different but not unrelated concern is whether utility regulation in general can adequately judge what levels of performance network customers want, and what arrangements with companies are best suited to achieving these aims. I wonder whether it would be possible to give customer representatives in each area a more leading role in determining the form, duration, content and

17 Information and Incentives Project: defining output measures and incentive regimes for PES distribution businesses, Update, March 2000; Output Measures and Monitoring Delivery between Reviews, Initial Proposals, June 2000; Output Measures and Monitoring Quality between Reviews, Final Proposals, September 2000. 18 For example, Tony Jackson, Towards Enduring Regulation, The Utilities Journal, May 1999, pp. 30-2. An argument for a rolling historical benchmark formula is given by Richard Dobbs and Matthew Elson, There is an alternative to RPI-X, Power UK, Issue No. 70, 17 December 1999, abbreviated from their article in McKinsey Quarterly, 1999, Number 1.

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level of the network price controls. The regulator might remain as a backstop in the event of failure to agree. The aim would be a set of price controls more like contractual arrangements negotiated between customer representatives and the companies. Such arrangements might involve the specification of investment programmes, or they might involve incentives and penalties, or both. They might extend over a period of two years, five years or fifteen years. These would be matters for negotiation in each area. A greater diversity of approach than hitherto could be expected, with more innovation and greater learning from experience. Generation market structure Excessive market power in generation has been a concern ever since the industry was privatised. To some extent market forces could be relied on to deal with this, but not necessarily as quickly as customers and competitors would like. Consequently, it has also been a continuing regulatory problem. Competition has developed in many ways. There has been greater use of the existing interconnector capacity, as well as the expansion of the Scottish interconnector. Nuclear plants have increased their output by about 75%. There has been new entry from a variety of sources, especially by independent power producers (IPPs) building Combined Cycle Gas Turbines (CCGTs). There has also been divestment of 6GW of existing plant by National Power and PowerGen. The share of the original duopoly of these last two companies fell from nearly 80% at the time of privatisation to 40% in the year 1997/98. But still there were concerns. These were compounded, for the regulator and customers, by the governments decision, in Autumn 1998, to adopt a stricter consents policy, which appeared effectively to impose a moratorium on the construction of new gas-fired plants of significant size. As Graham Shuttleworth remarked, Offer and the government were then advocating

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further divestment of coal-fired plant by National Power and PowerGen to curtail their market power, to reduce spot prices and hence to eliminate any uneconomic incentives for construction of gas-fired generation. These two companies did indeed decide to divest further plant, for a variety of reasons. PowerGen divested 4GW of plant to Edison Mission Energy in July 1999, in relation to its acquisition of East Midlands Electricity. National Power agreed to divest its 4GW Drax plant to AES in relation to its acquisition of Midland Electricitys supply business. National Power later sold its 2GW Eggborough/Boron plant to British Energy and its 665 MW Killingholme/Nitrogen 1 plant to NRG; it also mothballed its 1 GW Blyth plant and closed other older plant. Then it reorganised itself into two quite separate companies (Innogy/Npower and International Power) and its Deeside plant went to International Power. PowerGen announced the sale of its 2GW Cottam plant to London Electricity/EdF in October 2000, to help finance its overseas expansion. The companies may also have decided to reduce their exposure to regulatory scrutiny, and to take advantage of favourable prices for generation assets as a result of the moratorium. The prospect of revised trading arrangements may also have stimulated the interests of other suppliers in owning generation. In addition to the disposals, new entry under construction before the moratorium was announced continued to come on stream. Table 1 shows the extent to which the structure of the industry had changed by 1997/98, and the further equally dramatic changes that have taken place over the last two years. The aggregate share of National Power/Innogy and PowerGen was down to 30% in 1999/2000, and to 25% in the six months April to September 2000.

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Table 1: Shares of generation output in England and Wales since privatisation

Generating company/ year

1989/90* 1990/91 1997/98 1998/99 1999/00 Apr-Sep 2000

National Power/Innogy 48.0 45.5 21.0 21.1 17.5 11.1PowerGen 30.0 28.4 19.6 17.7 15.3 14.7Nuclear Energy/ British Energy

16.0 17.4 17.3 17.8 15.8 19.6

French Interconnector/ EdF

3.5 5.9 5.7 4.2 5.1 7.6

ScottishInterconnector/ SP/SSE

1.5 1.2 6.1 6.3 8.4 8.4

Pumped Storage/ Edison ME

0.5 0.6 1.4 1.4 5.0 5.5

Others 0.5 1.0 1.0 0.6 0.9 0.7Other new entrant IPPs - - 10.3 12.4 14.4 13.6Eastern/TXU - - 9.7 9.6 7.3 6.3Magnox Electric - - 7.5 8.1 6.7 4.5AES - - 0.5 0.9 3.5 8.1Total (%) 100 100 100 100 100 100Total Output (TWh) 256 266.8 287.1 294.5 293.5 137.9 Source: Offer and Ofgem. *Hypothetical attribution based on allocation of plant at privatisation. The market abuse or good behaviour licence condition Despite these structural changes, customers and Ofgem continued to be concerned that market power was still being exercised. In May 1999 Ofgem published a decision document about price spikes in the pool during winter 1998/99, warning that it would continue to monitor prices. In July 1999 it investigated the high prices at the beginning of that month. It acknowledged that the number of new generators selling through the pool had increased substantially, from 8 at vesting to 38 in 1999. But it was concerned that there was limited competition in price setting. The CCGTs of the new entrant, independent power

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producers did not compete at the margin and only rarely set prices (3% of the time in 1998/99). Three companies (National Power, PowerGen and Eastern) set pool price 86% of the time in 1998/99. Ofgem said that even though the recent divestments should increase competition in price setting, past evidence suggested that concern about the ability of certain generators to influence the price setting mechanism would remain.19 In October 1999 Ofgem concluded that a market abuse licence condition (MALC), better known as the good behaviour condition, needed to be introduced into the licences of the seven generators most likely to have market power. This provided that The licensee shall not engage in conduct, whether alone or with one or more other undertakings, which amounts to an abuse of a position of substantial market power in the determination of wholesale prices for electricity under the relevant trading arrangements. Possible examples of such abuse would be price bidding strategies, capacity withholding, manipulation of complex market rules and using the influence of contractual positions. To minimise regulatory uncertainty about the operation of the condition, Ofgem issued guidelines about its interpretation. These provided that a licensee will be regarded as having a position of substantial market power if it has the ability to bring about, independently of any changes in market demand or cost conditions, a substantial change (over 30m) in wholesale electricity prices. Substantial changes in price might refer to a few very large effects or a series of lesser ones. For example, it would include a change of 5% for more than 30 days (1440 half hours), or 15% over 10 days (480 half hours) or 45% over 160 half hours (3 1/3 days), all within a one year period.20 To help ensure there were no major departures from best practice in other

19 Rises in Pool Prices in July: A Decision Document, October 1999. 20 Introduction of a market abuse condition into the licences of certain generators, Ofgems initial submission to the Competition Commission, May 2000.

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public policy areas, Ofgem also appointed an advisory board of experts on competition policy and financial markets. After a lengthy discussion process lasting until April 2000, five generators consented to the condition: Magnox Electric, TXU Europe (formerly Eastern), Edison Mission Energy, National Power/Innogy and PowerGen. Two generators (AES and British Energy) did not consent, and Ofgem referred them to the Competition Commission in May. Ofgem argued that other possible remedies and developments (further divestment or revised generation market structure, modification of pool and NETA rules, the introduction of NETA itself, the Competition Act 1998 and Financial Services Regulation) would not suffice to prevent such abuse. This was because of the specific conditions of electricity: the need to match demand and supply instantaneously, the non-storability of electricity and the limited demand side response. Shortly afterwards, Ofgem carried out its first investigation under the market abuse condition in the licence of Edison First Power.21 The company had withdrawn 480MW of capacity from the system. Ofgem concluded that the company had substantial market power, which it had exploited to the detriment of consumers. Specifically, the continued withdrawal of capacity was not justified on the basis of avoiding losses, and had materially increased prices in the pool and the forwards markets. This was to the detriment of over 200 large customers purchasing electricity on pool-related terms, and other respondents were harmed by the increase in pool uplift. Because the company announced that it would return the capacity to the system, Ofgem took no further action. In contrast to previous Monopolies Commission proceedings, an interesting and novel feature of Competition Commission proceedings is that participants are encouraged to publish their

21 Ofgems Investigation of Edison First Power under the Market Abuse Licence Condition: Initial Findings, July 2000.

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submissions. Ofgem published over a dozen submissions and related papers on this case. These included further evidence of historic market manipulation and of the scope for AES and British Energy to exercise substantial market power, both under present pool trading arrangements and also under the New Electricity Trading Arrangements (NETA) that are scheduled to replace them (see below). There are also Ofgems rebuttals to the arguments of the dissenting generators. They typically argued that electricity was not as special as Ofgem claimed, that the market was and would be more competitive, that Ofgem had not substantiated the problem, that MALC was not appropriate, and that they should not be subject to it. On 29 September Ofgem published a vigorous response to the Commissions potential remedies letter. Ofgem argued that it would be better to have a general effects-based condition than a condition prohibiting specified kinds of conduct. It also expressed concern that the Commissions potential remedies applied mainly to existing trading arrangements whereas it was important to have the condition in place under the new trading arrangements, especially while they were bedding down. The need for, and desirability of, a market abuse licence condition is much debated by generators and others.22 Some see it as further evidence of inappropriate regulatory intervention in an increasingly competitive market. There has indeed been more diversity in price setting since the condition was first proposed. By April 2000 there were seven companies regularly setting prices in the pool. The aggregate share of pool price setting of the three companies mentioned earlier fell from 86% in 1998/99 to 67% in 1999/2000; in the first six months of 2000/01 it was 41%. On the other hand, Edison Mission Energy still had a price-setting share of 24% in the first three months of 2000/01,

22 For one critique, reflecting his evidence to the Commission, see Alex Henney, Market abuse or regulatory abuse? PowerUK, Issue 78, August 2000, pp. 18-21. Ofgem published its comments on this submission on 15 September.

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and was held to have possessed and exercised substantial market power, to the detriment of consumers.23 Under the new trading arrangements described below, prices will be largely determined by bilateral contracts between buyers and sellers. There will no longer be a uniform system marginal price that all sellers get and all buyers have to accept. The market should then be less vulnerable to the bid price of a particular marginal generating set when. Even so, Ofgem argues that the need for the condition will remain even when the new trading arrangements come into effect. It says that it would not be prudent to assume that increasing competition and the new trading arrangements will together be sufficient to eliminate all cases of substantial market power. Nor will the 1998 Competition Act provide sufficient powers. In Ofgems view, the proposed condition is necessary so long as there is a divergence between the Competition Act concept of dominance and Ofgems concept of substantial market power. The former requires a market share generally over 40%, typically the largest market share. In contrast, Ofgem has suggested that any party with an output or price-setting market share above 5% can potentially exercise substantial market power.24 Those countries, and states in the US, that have moved furthest towards competitive electricity markets are actively grappling with similar questions. Are price spikes an intrinsic feature of electricity markets? If so, are they always a reflection of high cost or scarcity, that send valuable signals to all market participants, or do they sometimes represent market power that could and should be curbed? How can they be distinguished and how best to regulate? There is no international consensus as yet, and despite the likely drawbacks of a market abuse condition, especially in terms of implementation, it is not obvious that the

23 Although Edison First Power had a share of only 17%, First Hydro (formerly Pumped Storage Company), also owned by Edison Mission Energy, had a further share of nearly 7%. 24 Ofgems second submission in support of Competition Commission referral, June 2000.

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generation price caps and other measures being discussed elsewhere represent a better answer.25 Removing the straightjacket of compulsory bidding into a pool, with its uniform system marginal price, and putting in place full retail supply competition without pass-through of generation costs, will limit market power and encourage long-term contracting to minimise risk and vulnerability. I suspect that these measures will greatly help to resolve the problem.26 The Commissions decision was due in November 2000, but on 21 October Ofgem agreed a six week extension. On 12 December the Commission concluded as follows:

We have not therefore identified adverse effects which need to be addressed by the inclusion in the licences of AES and British Energy of a condition prohibiting abuse of market power. Moreover we think that such a prohibition would cause uncertainty, because of the difficulty of distinguishing between abusive and acceptable conduct, and would risk deterring normal competitive behaviour. Competition should be given the opportunity to work in the new circumstances of NETA, and with a less concentrated generation sector, without the introduction at this stage of new broadly framed regulation.

The director general said that he was deeply disappointed, I regard this as a substantial loss of measures needed by Ofgem to do our job. This is to the detriment of consumers whose

25 See for example Ofgems discussion of some US experience and arguments in, The importance of the Market Abuse Licence Condition for the protection of consumers and competition, Final Submission to the Competition, November 2000. In California (see below) feelings are particularly strong but also divided on the merits of hard or soft generation price caps as a means of curbing generator market power. 26 For a similar view see Ofgems Final Submission, page 5. Whether more active demand-side participation will contribute significantly in the next few years remains to be seen.

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protection is Ofgems new primary objective under the law. He added Ofgem will withdraw from regulation wherever it can properly do so. We have a duty to try to make competition work in the interests of the consumer, and we will continue to do so. Policy on new entry Over the longer term, new entry is central to the alleviation of market power. The governments policy on entry is therefore of crucial importance. In the October 1998 White Paper on Energy Policy, the government confirmed the preliminary conclusion in its June 1998 consultation document. It said that until certain distortions in the energy market were removed, it intended to maintain a presumption that new gas-fired stations would normally be inconsistent with the governments diversity and security of supply concerns. In practice the government made exceptions for the construction of small combined heat and power (CHP) plant. But it appeared inconsistent and subject to political influence on large plant. For example, it disallowed the construction of a new 700MW CCGT at Gartcosh in Scotland on the grounds that this would discourage people from coming in and regenerating the area. Commentators noted that Scottish Power is against the plan [for Gartcosh] saying that there is too much capacity already in the Scottish market and that the gas plant would displace its coal stations so decimating the Scottish mining industry.27 But in March 1999 it gave section 14 consent for a 500MW CCGT at Baglan Bay in Wales on the grounds that it would entail the construction of an energy park that would attract business to the area. Commentators noted that this was just before the Welsh elections. They also found it difficult to reconcile this decision with the previous Gartcosh decision.

27 Power UK January 1999.

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Then in July 2000 the government approved a proposal to construct a 560MW CCGT on Anglesey, also in Wales, partly on the grounds that this could help stem the labour flow out of Anglesey and attract industry back to the area. It is clear that political factors now have more influence in new generation decisions than they used to. There is correspondingly more scope for incumbents to seek to influence government policy in order to limit competition, as a more profitable alternative than competing on price. In April 2000 the government announced that it would lift the stricter consents policy when the new trading arrangements came into effect. The latter date has since been delayed (see below), but the government nonetheless lifted the stricter consents policy on 15 November 2000.28 At the same time it announced the approval of six CCGT schemes totaling 4840MW, and welcomed the European Commissions approval of a 110m scheme to help the coal industry through a period of transition. The government also indicated that it intended to use consents as a vehicle for other policy objectives.29

28 Byers announces major development in the energy sector, DTI Press Notice 15 November 2000. 29 The power station will make an important contribution to the Thames Gateway regional initiative. The developer has indicated that if the development goes ahead, it will be willing to supply waste heat to nearby community heating projects and companies. In addition the Company has agreed to provide electricity at a significantly reduced price to local business and those who are attracted to locate there when the proposed redevelopment of the area takes place. The government has indicated that it expects developers to explore opportunities to use Combined Heat and Power, including community heating, when developing proposals for new power stations. Guidance will shortly be issued to developers on this subject. Henceforth developers submitting new proposals will be expected to show that such opportunities have been thoroughly probed in line with Guidance which my Department will publish shortly. Government Gives Consent for Isle of Grain Power Station, DTI Press Notice, 15 November 2000.

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Review of trading arrangements In October 1997 the DTI announced a review of the electricity trading arrangements in England and Wales. In last years review Graham Shuttleworth described the concerns about the present arrangements in the pool that had led to the review, the extensive public consultation process that then took place, and the nature of Offers proposals in July 1998. Hitherto there have been centralised and compulsory arrangements whereby, essentially, all generators have to sell into the pool and all suppliers had to buy out of the pool, for each half hour of each day, at a uniform price in each half hour determined by the GOAL scheduling model. Under the proposed new arrangements, these restrictions would disappear. Instead, market participants would negotiate contracts bilaterally, on whatever terms best suited them, for however long ahead they chose. There would also be an organised but voluntary exchange to facilitate trading in the 24 hours ahead of the actual day. In the 4 hours ahead of each real time half-hour, a balancing mechanism would reconcile traders contract positions with actual generation and demand. Graham Shuttleworth noted that many aspects of the proposals had yet to be resolved, expressed reservations about the reliability of the conclusions, and wondered whether the secretary of state would support them. The secretary of state did in fact accept Offers proposals, as explained in the October 1998 white paper. Ofgem continued the extensive consultation process that Offer had initiated, set out further detailed proposals in July 1999, and summarised its conclusions jointly with DTI in October 1999.30 The key issues were relatively technical ones, relating to the operation of the balancing mechanism and the calculation of prices for cashing out imbalances. They included the timing of contract notification, separation of production and consumption

30 The New Electricity Trading Arrangements, Ofgem/DTI Conclusions Document, October 1999.

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imbalance volumes, meter splitting and aggregation, flexible governance, and arrangements for CHP and renewables. Proposed changes to licences were published in June 2000. The new balancing and settlement code (BSC) was signed in August 2000. The documents also formally put in place Elexon, the company that will administer aspects of the new electricity trading arrangements (NETA), and the BSC Panel, which will include representatives from the industry and customers and supervise the delivery of services and the modification process of the BSC. For some time the planned go live date for NETA was 21 November 2000. The main uncertainties concerned the end-to-end testing of the central systems and those of the industry participants. On 15 September 2000 Ofgem announced a delay to the start of end-to-end testing of these systems. It subsequently said that go live was no longer possible before Christmas, and on 27 October announced a new target date of 27 March 2001.31 Arguments will no doubt continue for some time as to the merits of the new arrangements. There is no shortage of critics, including from overseas.32 They argue that although the pool had limitations and was inflexible, it was transparent, cheap and secured efficiency in terms of a uniform price in any half hour. They suggest that it would have been better to patch it up by

31 Ofgem subsequently (21 November) published the readiness indicators that would inform the decision in January 2001 as to whether there had been sufficient progress in testing systems to enable the new go-live date to be met. 32 For example, Catherine D Wolfram, Electricity markets: should the rest of the world adopt the UK reforms? University of California Energy Institute, October 1999; Larry Ruff, Competitive Electricity Markets: One Size Should Fit All, The Electricity Journal, November 1999, pp. 20-35; Jack Neushloss and Fiona Woolf, Review of the England and Wales Trading Arrangements: The Proposal to Cure the Ills by Euthanasia of the Pool, The Electricity Journal, December 1999, pp. 27-36.

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moving towards real-time pricing, reforming its governance, and perhaps allowing participants the option of trading outside the pool. They suggest that the new arrangements may be inefficient and costly, and more vulnerable to exploitation by generators in particular locations. The counter-arguments for the proposed new arrangements reflect scepticism that the pool could have been changed in the ways proposed. In any case, any such modification would still have been unduly restrictive. A uniform price would continue to render the system vulnerable to erratic marginal prices and be conducive to the exercise of market power. Contracts for differences around pool prices would still be hampered by the limitations of the pool pricing procedures. The new arrangements based on bilateral trading should be more stable, cost-reflective and flexible, and thereby more conducive to competition, efficiency and innovation over the longer term. As to transparency, under the pool that is more apparent than real, since almost all pool transactions are hedged, and the prices of hedging contracts are not public. In future, price reporters could be expected to report trends in contract prices, and indeed that is already happening. Concerns about scope for exploitation were to be addressed by more detailed specification of the trading arrangements; by the role of NGC, to which much thought has been given;33 by the introduction of new market-based transmission access arrangements; and by the market abuse licence condition. Ofgem also points to empirical evidence that NETA and other changes are already producing lower wholesale prices in the forward markets, and that whenever NETA is rumoured to be delayed the forward prices rise.

33 NGC Incentive Schemes from April 2000, A decision document o