Price proposals may force mergers

Recent price control proposals announced by the UK electricity regulator for the country`s distribution companies have been described as “tough but fair”. But the electricity suppliers say they will struggle to meet the cost reductions needed under the proposals – perhaps mergers will be their only way out.

Siân Green reports.

The UK`s electricity regulator published its outline price proposals for the electricity distribution businesses in Great Britain in mid-August. If implemented, the proposals will see a reduction in distribution prices of up to 30 per cent in the first year, and could have wide-reaching implications for the 14 public electricity suppliers (PESs) in Scotland, England and Wales.

The Office of Gas and Electricity Markets (Ofgem) has proposed a reduction in distribution prices for the year 2000/2001 of between 25 and 30 per cent followed by an annual price cap of three per cent below inflation for the period to 2005. The proposals are due to be finalized in November 1999 after a period of consultation, and will take effect in April 2000.

Given that distribution charges make up around one third of a typical domestic bill, the proposals would reduce the average household`s bill by around five per cent. In announcing the proposals, director general of electricity supply Callum McCarthy said: “I regard these proposals as tough, fair and realistic. [The] proposals offer benefits and opportunities for customers, companies and investors.”

The large price reductions for the year 2000/01 include a reallocation of costs from the PES` distribution businesses to their more competitive retail supply units. These costs include billing, meter reading and advertising and marketing, and account for nearly one third of the cuts; the remaining two-thirds of the cuts for 2000/01 will require straightforward savings in capital and operating expenditure.

Each PES is effectively a regional monopoly and so is subject to price controls and quality of service standards. McCarthy believes that these proposals will provide the PESs with strong incentives to improve their efficiency and service; he stated that the price cuts will give a balance between efficiency, consumer needs, shareholder interests and raising revenue for investment.

Most of the PESs disagreed, however, as distribution charges account for the majority of their operating cash flow. Although the price caps will keep domestic consumers happy – those in south Wales could see savings of up to £28 ($45) on their annual electricity bill, most PESs will take a substantial hit on their revenue.

The worst hit PESs include United Utilities` Norweb with a 30-35 per cent price cut, Central & South West Corp.`s Seeboard with a 37-42 per cent cut and Hyder`s Swalec with a 29-34 per cent cut. United Utilities` shares fell by over six per cent on the news.

Unsurprisingly, most PESs reacted badly to the announcement. Although some were measured in their public response to the proposals, saying that they needed time to study the implications, others were more candid. MidAmerican Energy Holdings, which owns Northern Electric, said that it would seek an `acceptable` price control through talks with Ofgem, but if this is not achieved, it will consider all legal remedies, including an appeal to the Competition Commission. Thomas V. Shockley III, Central & South West Corp. president and chief operating officer said: “Ofgem`s proposals seem to penalize Seeboard`s efficient performance.”

Central & South West said the proposals could result in a net income reduction of $40-50m in year 2000/01 for its Seeboard business. The impact on PowerGen`s revenues could be £30m, Scottish and Southern will take a £60m hit while Swalec and Norweb could see revenue reductions of £20-25m. Northern Electric said that the price cuts could result in up to 800 job losses.

Least affected will probably be Scottish Power, whose diversified structure will help to insulate it from the proposed price cuts. Scottish, which owns Manweb, also has interests in water, gas and telecoms.

But the proposed price cuts could have more far-reaching and long-term impacts than dividend cuts and revenue hits. They will force the PESs to realise considerable cost efficiencies while still maintaining quality of supply standards and investing in their networks. A sensible way to realise these savings would be to merge with another distribution business.

The supply end of the UK electricity industry is already moving towards a separation of the distribution and retail supply functions that the PESs carry out. This is largely being driven by another Ofgem proposal also currently under consultation. Although the PESs are required to keep these business activities separate, Ofgem wants more complete separation to ensure the neutrality of the distribution units with respect to competing retail supply and generation interests. While most PESs are concerned about the costs of implementing this separation, three have already decided to hive off their retail arms.

Earlier this year, Hyder sold the retail arm of Swalec to British Energy, and Southern Co. and Pennsylvania Power and Light sold the supply business of Sweb to EDF-owned London Electricity. The retail unit of Midlands electricity is also in the hands of generator National Power. Given that the regulator wants to move certain functions from the distribution side to the now highly competitive supply side of PES business, such consolidation could be expected to continue as margins get tighter.

The proposed separation of these business units, and the proposed price cuts to be implemented in April 2000, may therefore see PESs look to each other for distribution partnerships. The only comment that McCarthy had on this idea, was that he would like to see such a merger referred to the Competition Commission. And then what – more price caps?

In response to the proposals, Duff & Phelps Credit Rating said that “these may well be the last significant level of cost savings that can be squeezed from these businesses without im- pairing long-term investment”. Encouraging competition is one thing, forcing mergers is another.

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