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European Affairs
Special Report: Transatlantic Approaches to Energy Policy
Energy Deregulation Does Not Have to End in Tears
By Callum McCarthy
Britain's experience with the privatization and liberalization of its gas and electricity industries, which it started 15 years ago, suggests that deregulation need not end in tears with a "California style" energy crisis. This article explains why, and then takes a brief look at the energy policy agenda we are now working on in Britain.
The previously state-owned gas industry, then a vertically integrated monopoly, was privatized in 1986. The electricity industry, including generators, grid and supply, followed in 1989. There have been many developments since then, including the full opening up of the supply market to competition.
Since May 1999, every consumer in Britain (domestic, industrial and commercial) has been completely free to choose its supplier of gas and electricity. Competitive market forces now drive the market - there are no price tariffs set by the regulator for gas and only residual controls on electricity tariffs.
At the heart of our work is the belief that the interests of consumers are best served by promoting competition wherever possible and maintaining effective regulation where it is not.
Central to the gas and electricity industries are the monopoly transportation businesses: Transco for gas, National Grid Company for high voltage electricity transmission and the 14 regional low voltage distribution networks. In our view, crucial to the development of competition has been the separation of the monopoly activities from the competitive activities of generation (production) and supply. The value of vertical separation cannot be overestimated. It is key to ensuring a level playing field for competition.
A requirement for vertical separation should be, therefore, at the very core of the new European legislation (in May 2001 the European Commission proposed a new directive and regulation aimed at completing the internal market). This vertical separation, together with non-discriminatory terms for network access, has facilitated competition. This creates a downward pressure on prices, which feeds all the way up the supply chain.
The effect of bringing competition to energy wherever possible, and the fair return regulation of the natural monopolies, is clear. Prices have fallen by 37 percent in real terms for domestic gas customers and by 28 percent for electricity customers between 1990 and 2001.
Competition is strong and continues to develop: 37 percent of domestic gas customers and 38 percent of domestic electricity customers have switched suppliers; more than 150,000 switch every week. Both those who switch and those who stay with their original suppliers benefit from the downward pressure on prices which competition has brought and continues to exert.
And all this has been achieved without any deterioration in customer standards, which have actually improved, and without any deterioration in security of supply. Britain has a more diverse energy mix today than it has had at any time in its history. Interruptions to supply, whether in gas or electricity, are even more rare today than they were a decade ago. Our generating margin over peak demand stands at just under 30 percent.
It is important to recognize that competitive and deregulated markets need not produce another California, and indeed can bring very real benefits. That is the British experience; it is also the experience of the Nordic countries in Europe and the experience of individual states in Australia.
There is not much that is obviously wrong with this system, and those who search for market failures to correct have some difficulty in finding them. It is even more difficult, and in our view not possible, to demonstrate that there is an administrative solution that will yield a better outcome.
There are, of course, issues that exercise Government. There are the geopolitical issues, which arise for any country dependent on imports - a set of concerns that has long been apparent for oil, and which is becoming apparent for gas. As was always predicted, at some stage, Britain will become a gas importing nation rather than a gas exporter.
These questions necessitate a major political choice - for Britain and every other country. There are questions of fuel diversity and the balancing of environmental and economic goals. It is our view, and one based on experience, that the information needed to answer these questions by those involved is best generated by efficient and competitive markets.
There are, however, a series of residual issues, which I call the energy policy issues. Even though there is nothing that is obviously wrong with them in Britain, it is worth running through the present objectives that direct the government in its current energy policy review:
The process of increasing allowed revenue by changes in the well established formula to regulate prices, which dates from industry privatization - Retail Price Index (RPI) less some number (x) - has been good at driving efficiency gains and reducing prices. The challenge now is to meet the growing demand in network services.
Developing the RPI-x form of price control to ensure it gives the right signals and incentives for timely investment in network capacity in response to demand shifts is key to ensuring long term security of supply - this is particularly important for gas.
Other objectives include thinking through the effects on the regulatory regime of changes in technology, particularly distributed generation (e.g. smaller forms of generation embedded in the distribution system) and small-scale cogeneration (e.g. combined heat and power), and developing market signals for investment in the gas and electricity networks, for on the day operations and for gas storage.
It is important to develop a regulatory system for natural monopolies that encourages timely investment in the network. In December 2001, the Office of Gas and Electricity Markets (Ofgem) issued final proposals that strengthen the incentives for Transco to make new investment in the National Transmission System in order to meet customer demand.
The New Electricity Trading Arrangements (NETA) introduced in March 2001, has proved a significant success, with a remarkable drop in wholesale prices. NETA will have to be developed to deal with the challenges posed by new technology, distributed generation and small-scale cogeneration.
An important focus of Ofgem's work will be to ensure that market responses to market signals are properly developed to encourage the necessary investment in the gas and electricity networks.
There remains a significant regulatory reform agenda. The important point to note, however, is that with increasing competition, Ofgem will have withdrawn from nearly 70% of the activities subject to regulation at the time of privatization, and will only control prices of the core network monopolies. An increasingly deregulated market for gas and electricity in Britain is working, and working well. It has delivered large benefits to consumers in terms of quality, supply and price. Security of supply has not been at risk.
More broadly, some essentially political questions remain, of which the choice between environmental and economic priorities is probably the most important. But within the regulatory regime, the developments we intend to make are designed to build upon, not to replace, the foundations we have established and which are serving us very well. o