The UK electricity industry is about to go through its second major upheaval in ten years. Will the proposed Utilities Bill deliver the level of competition promised, or is it merely a mechanism for control by a regulator backed by a government that won’t let market forces lie?
Electricité de France’s (EDF) top management is committed to implementing the EU directive on electricity liberalization.” The statement from EDF’s Jack Cizain of speaking at a conference in London was controversial – even comical – given current relations between the UK and France over electricity deregulation. The frustrations of UK utilities with France’s stance on deregulation are clearly evident, but this is not the only obstacle they face as they try to gain ground in Europe’s energy markets. It seems their greatest source of frustration is the UK government itself.
Figure 1. Regulatory and government interference will undermine investor confidence in the UK electricity market
Speaking at the Institute of Economic Affairs’ annual conference, UK Energy ’99, several players in the UK electricity market aired their grievances towards the government’s energy policy, and their frustrations towards the regulator. The gas moratorium, forced capacity divestments, price caps and other regulatory mechanisms, have forced the utilities into a tight corner: meaningful returns in their home market are hard to find, and the prospect of competing in Europe against giants such as EDF and RWE are too daunting.
And planned legislation that will implement new trading arrangements as well as other structural changes in the electricity market of England and Wales is unlikely to make life easier. National Power’s recently announced planned demerger confirms this.
An agenda for reform
Conference chairman Dai Bedford of Gemini Consulting began the conference by setting a theme: “What does the future hold for the UK energy industry?”. This was a question perhaps best avoided, but was answered by Anna Walker, Energy Director General of the Department of Trade and Industry in her opening address on the future direction of UK energy policy and regulation.
The Labour government’s energy policy is clear, said Walker, in that it wants a competitive market that will deliver diverse, secure and sustainable supplies. This policy was presented in the government’s 1998 White Paper drawn up in response to fears of market dominance by certain players. The White Paper laid out a reform agenda for the electricity market designed to achieve a ‘level playing field’ for all participants. At the same time, the government implemented the ‘gas moratorium’, preventing the construction of new gas-fired capacity.
The reform proposals have now been bundled into a new legislative framework – the Utilities Bill – that the government hopes to pass by the end of the present parliamentary session. The Bill contains two major sections of reform: the new electricity trading arrangements (Neta) that will replace the power pool system in England and Wales with a commod-ity-style trading system; and the sep-aration of distribution and supply functions of public electricity suppliers (PESs) to promote competition in supply.
Walker said that the proposed legislation places an emphasis on consumer, social and environmental needs. The regulatory system will play a large part in achieving such objectives, and the government itself will be able to put forward “broad issues” for the regulator to take into account. In particular, said Walker, the government wants the market and the regulator to help reduce the 4.4 million “fuel poor” in the UK, and to improve environmental performance through efficiency targets, support for renewables, a climate change levy and emissions trading.
The government has been vague on exactly how security of supply will be achieved through this legislative framework, and Walker followed suit. Noting that coal and nuclear will have a declining share in generation over the next ten years, she said that a competitive market will help to promote security, but that government intervention may be needed.
The promotion of competition is clearly important to the government, however, and anti-competitive behaviour will be punished under new legislation planned for March 2000. Fines for anti-competitive behaviour could reach ten per cent of turnover, and third parties affected will also be able to sue, according to Michael Cutting, Partner at law firm Linklaters and Alliance.
Walker criticised those countries whose electricity markets remain closed, and said that the government would press for early market opening. “Our markets are fully open – we want the same in Europe.”
Cutting, who spoke on the implications of the proposed legislation for utilities, noted the strong consumer focus of the Bill, a theme that was picked up by Dr Eileen Marshall of regulator Ofgem in her presentation. To date, 26 per cent of domestic gas consumers have switched supplier, while 13 per cent of electricity consumers have switched. This, stated Marshall, was “more than many had predicted”, and proved that competition benefits consumers. “The market is in a good position, but that doesn’t mean it cannot be improved,” said Marshall.
Marshall said that Neta and the proposed separation of distribution and supply functions will help to enhance competition. Separating distribution and supply, said Marshall, will remove concerns over the cross-subsidy of the competitive supply units by the natural monopoly business of distribution. PESs will be required to transfer their distribution or supply unit to a newly created company with a separate name, brand and licence by April 2002.
Marshall recognised, however, that “Neta is not the whole answer”. Commenting on the promotion of competition in generation, she said: “We need more divestment together with the removal of the strict consents policy by the government to encourage more entrants.”
Can competition prevail?
True competition will be difficult to achieve, according to Dr. Dieter Helm, director of Oxera, who said that a natural oligopoly with marginal competitors is likely to prevail in the electricity market of England and Wales.
Interestingly, Helm was the first speaker to mention the needs of shareholders in this privatized industry. For all the importance given to consumers, social needs and the environment by the government, Helm pointed out that “shareholders do count in this game”. He added that the cost of capital of UK utilities is high compared to US utilities.
The proposed reforms will not work in favour of the market, according to Helm, and will not decrease the cost of capital. He said that the reform process has been driven by “consumer popularism” and the desire to cut prices to final consumers, and that throwing social and environmental objectives into the mix would be costly. Trying to marry social responsibilities with price reductions will result in utilities being squeezed from all sides.
Helm believes that the fundamental problem with the reforms is that the government has not bothered to find out what was really wrong with the pool system: was it the pool mechanism itself or merely the behaviour of the parties involved? If it was the latter, then the reforms are unlikely to make any difference.
Nevertheless, Helm applauded the decision to separate distribution and supply units. This could lead to greater efficiencies as the two functions require a totally different skills base. Helm believes that this will lead to market restructuring resulting in horizontally and vertically structured utilities.
A player’s handicap
Criticisms of the government’s energy policy was reiterated by other speakers, including Ed Wallis, chairman and chief executive of UK utility PowerGen plc. Talking on “Expanding the business – domestic and international responses to the competitive market”, Wallis emphasised the importance of size and structure in attaining success on a national and international scale.
Originally created in 1989 alongside National Power as a generation company, PowerGen realised early on the importance of having a vertical structure. This, said Wallis, gives the company the ability to compete head-on in the supply market, manage risks and take advantage of synergies without putting consumers at risk. Several attempts to buy regional supply companies were thwarted by the regulator until 1998 when it was finally given clearance to purchase East Midlands Electricity.
Wallis also explained the benefits of PowerGen’s ‘dual fuel’ approach. Bringing in revenues from a source other than electricity brings synergies and risk-reduction potential and is helping the company to bring in new customers every week. Wallis said that when the domestic sector of the electricity market was opened to competition, PowerGen was losing around 20 000 customers per week, mainly to British Gas. Now, says Wallis, this has been turned into gains of around 16 000 per week.
Talking on the UK market, Wallis recognised the need for a regulator but said that a sense of balance, with consideration for the shareholder, is required. He said that the, “consumer is king” approach is a fallacy that would result in long-term damage and undermine share price and consumer confidence.
Figure 3. EDF’s position in France, and now Germany, stands it in good stead for the future
Europe is a different story for PowerGen. Wallis admitted that the utility is at a major disadvantage to what he called “the national champions” such as RWE, Enel and EDF, and put this down to the forced capacity disposals imposed by the regulator. In terms of generating base, both PowerGen and National Power are roughly one-tenth the size of EDF and a third of the size of a combined RWE-VEW and a combined Veba-Viag. This will prevent them from competing meaningfully in Europe, and explains PowerGen’s forays into the USA in search of partnerships that will help it reach “critical mass”.
PowerGen’s experience of the UK market would serve it well in the USA, according to Wallis, but he made it clear that the company had no intention of paying over the odds to get what it wanted. Wallis said that PowerGen is limited by its size and shareholder price, and added: “The UK authorities have handicapped us”.
A success story
The first UK utility to seal a deal in the USA is Scottish Power, whose CEO Ian Robinson spoke to delegates on strategies for creating a global multi-utility. Robinson was less critical of the government than other speakers, but acknowledged that regulation had become more intense, and warned of “threats” ahead for his business.
Scottish Power recently cleared the last hurdle in its purchase of PacifiCorp of the USA with regulatory approval from Utah state. The newly merged company will be in the top ten global electricity companies with 7.5 million customers, a market capitalization of £10 billion and revenues of £6 billion. This triumph is a continuation of what Robinson called a “ladder of evolution” in search of a global leadership position.
Robinson stressed the importance of “growth, not for growth’s sake, but growth to gain value.” Since privatization, the company has grown from an electric utility into a ‘multi-utility’ with strong assets in gas, water, waste water, telecoms, internet services and electrical retailing. And in doing so, it has achieved a number of ‘firsts’: the first UK electricity company to purchase a regional electricity supplier, and to buy a water company, and to enter the US market.
Its strategy, according to Robinson, is simple and consistent: to get the best out of its existing assets and to leverage its skills base into new areas. For example, it had a small private telecoms network and used this as a springboard into telecoms; just a matter of weeks ago it successfully floated 49 per cent of its telecoms arm, ‘thus’, with a market capitalization of
Customer service and quality of supply are important, said Robinson. “You cannot sell the second and third product if you do not sell the first product well.”
Looking to the future, Robinson recognised both opportunities and threats. In the USA, he sees great potential in PacifiCorp due to its geographic base and generation and transmission assets. Robinson is looking forward to being able to “tune the company” as he did with Manweb and Southern.
Commenting on the UK, he said that the market must be allowed to move forward. Scottish Power’s greatest potential is in capitalising on its existing customer base with new services such as internet services, and financial and retail products. “The home is our territory!” said Robinson.
The importance of creating value and size was expounded by Dr. Nigel Burton, managing director and head of utilities at Deutsche Bank, who provided an insight into growth opportunities in Europe, and into who would become the major players. Critical of the UK’s regulatory system, he pointed out the German system where competition has brought a decrease in prices without the presence of a regulator.
Burton identified Germany as providing opportunities for investment. Here, he said, utilities will be prevented by the cartel office from buying up much more in the home market, providing international players with a few rich pickings – EDF has already agreed to buy a stake in EnBW.
In terms of growth opportunities in generation, Burton said that there are few due to an overcapacity in Europe. This will make it hard for new players to enter the market, except in Italy where 15 GW of capacity will be divested by 2003.
For the major players of the future, Burton said that size would be important, giving the obvious candidates – EDF, RWE, Enel and so on – a compelling advantage. He agreed with Wallis that no UK player is large enough to compete in Europe, but cited Eastern as having made significant ground in building up a pan-European portfolio of value. But Burton reminded delegates that from experience with other industry sectors, it is not always the ‘obvious’ candidates that win.
One speaker who was able to identify clearer opportunities in the UK and Europe was Cizain of EDF. Outlining the company’s growth strategy, Cizain said that EDF’s geographic location and proximity to Germany, where it is buying a stake in EnBW, stand it in good stead for becoming a leader in the European market.
In the UK market, it already has a presence in generation (by exporting through the interconnector) and in distribution and supply through its ownership of London Electricity and the supply arm of Sweb. EDF clearly wants to build on this base through vertical and horizontal integration, and will also look into the gas supply market. Although EDF is reported to have ruled out a bid for the newly demerged National Power, it certainly has its eyes fixed on the UK. “We are ready to enter dialogue with UK companies,” said Cizain.