The Impact of Privatisation on Electricity Prices in Britain
Presentation to the IDEC National Seminar on Public Utilities
Sao Paulo, August 6-8, 2002
Steve Thomas
Senior Research Fellow
Public Service International Research Unit (PSIRU)
School of Computing and Mathematics
University of Greenwich
30 Park Row
London SE10 9LS
UK
Tel: 44 208 331 9056
Fax: 44 208 331 8665
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The Impact of Privatisation on Electricity Prices in the UK
Consumers basically want two things from their electricity supplier: reliability of service and affordable prices. By these criteria, electricity privatisation in Britain appears to have been a success: since privatisation in 1990, reliability has remained excellent and prices to small consumers have fallen in real terms by about 25 per cent. This presentation focuses on the impact of privatisation on prices paid by small consumers, identifying why changes in price have occurred. The presentation falls into five main sections;
- The component parts of electricity bills and how they are calculated;
- Prices from 1990-98, when small consumers were still captive to their local retail supply (commercialisation) company;
- Prices from 1999 onwards, when small consumers were able to choose their electricity supplier;
- The role of pre-payment meters (PPMs) in the privatised industry; and
- The potential impact of structural changes currently underway to the industry.
1.The component parts of electricity bills
After privatisation, there were five main components to electricity bills. These were: generation, distribution, transmission, retail supply and a nuclear subsidy. Each was derived by a separate mechanism.
1.1Generation
In Britain, generation is split between gas, coal and nuclear power. In 1990, about 75 pe4r cent of power came from coal and most of the rest was nuclear. Now, coal and gas account for about 35 per cent each of generation, with the rest mostly nuclear. Generation represents the largest element of consumers’ electricity bills accounting for about half the cost. The change to the way in which generation was priced was the most radical and most important element of the 1990 reforms. Power generation was to be operated as a competitive market rather than as a monopoly. In the original design, the market (Power Pool) was a compulsory one with prices changing every half hour. In 2001, the Power Pool was replaced by the New Electricity Trading Arrangements (NETA), in which long-term contracts were expected to play the dominant role. While small consumers were captive to their local retail supply company, the retail supply company could only pass on to consumers the price they had paid for electricity from the wholesale market.However, they were able to allocate different purchases to different markets, and, for example, retail suppliers allocated their expensive electricity purchases to the captive market, while saving their cheaper purchases for consumers that were able to chose their electricity supplier.
Now, the overall tariff is unregulated and, effectively, retail supply companies are not restricted in what generation charges they can pass on to consumers.
1.2Transmission and distribution
The charges for use of the transmission and distribution system represented about 5 per cent and 25 per cent respectively of the bill for a small consumers. These two sectors were to remain monopolies and the price charged to generators and retail suppliers for using the networks was to be set by an independent regulator using incentive (‘RPI-X’) methods.
The methodology was originally very simple and required only that the Regulator set the regulated company an annual target for improving its efficiency that would apply for 3-5 years forward:the ‘X’factor. It was entirely the business of the company how it achieved the target, through investment in new equipment or productivity improvements.If the company could beat its target, it could keep the additional profits it made and if it could not, its profits would fall, hence the description incentive regulation. The results for the transmission sector are presented in Table 1. Overall, the reduction in prices since 1990 of nearly 40 per cent is remarkable, but closer examination of the data shows that the price reductions happened almost exclusively from 1997-2000, with one large price cut followed by three substantial cuts.
Table 1Electricity Transmission Prices (1990=100)
YearXPriceMean X
19900100
19910100
199201000
1993397.0
1994394.1
1995391.3
1996388.52
19972070.8
1998468.0
1999465.2
2000462.74.5
2001062.7
20021.561.7
20031.560.8
20041.559.9
20051.559.03.5 (3.0)
To understand how these remarkable price cuts were possible, it is necessary to change in the method used to derive ‘X’ that applied from 1995 onwards. By 1995, it was clear that prices could only be reasonably set by reference to the value of the assets employed and the British system became a variant of traditional rate of return regulation, although the results are still presented as an ‘X’ factor. Prices are set using the formula:
Each of the elements in this equation requires detailed and complex calculations, but the key factor in driving price reductions has been the value assigned to existing assets. In 1990, the companies were sold for only about a third of their accounting value.If the regulator had set the value of the pre-privatisation assets at their accounting value, investors would have been able to make a full rate of return on three times the amount they had actually paid for the companies. The Regulator therefore decided that the asset value allocated to the pre-privatisation assets would be the price the companies were sold for. This allowed large one-off price reductions when the system of price-setting was switched, in 1995 for distribution and in 1997 for transmission.
There are two important points to note. First, these price reductions were paid for by taxpayers because assets owned by taxpayers were sold for only a small fraction of their real value. Second, the price reductions will probably only be temporary as prices will have to rise as old assets are replaced by new assets paid for at the full market price. This trend is becoming apparent in the transmission sector and for the period 2001-05, prices will fall by little more than 1 per cent per year.
1.3Retail supply
These represent the costs incurred by the retail supplier and include metering and billing. At time of privatisation, these represented about 5 per cent of a typical bill, but some costs have been reallocated from distribution to retail supply and the percentage is now more than 10 per cent. While small consumers were captive to their local supplier, these charges were set by the regulator using incentive regulation methods. Now, companies are free to charge whatever the market will bear. Because a retail supply business has few physical assets, there was no scope for large price reductions from switching to rate-of-return methodology.
1.4The nuclear subsidy
Privatisation revealed that Britain’s nuclear power plants were heavy loss-makers and the plants could not be privatised in 1990. They remained in public ownership and were subsidised by a consumer subsidy, the Fossil Fuel Levy (FFL), the level of which was set by government. The FFL represented 10 per cent of all consumers’ bills and about half the income of the nuclear company. By 1996, the efficiency of the nuclear sector had improved and it was possible to privatise the more modern plants and remove the subsidy. Losses made by the older plants are now underwritten by taxpayers.
In part, the removal of the nuclear subsidy was possible because of efficiency improvements in the nuclear industry and this was welcome. However, it was possible partly because the burden of paying for long-term costs such as radioactive waste disposal and decommissioning was shifted from today’s electricity consumers to future generations of taxpayer. This runs counter to the ‘polluter pays’ principle and cannot be regarded as equitable.
2.Prices from 1990-98
Four out of five of the elements of consumers’ bills from 1990 to 1998 were set by the regulator or government and can be calculated.Given that the overall price was known, the remaining cost can only be the price paid for generation. Table 2 shows how overall prices developed from 1990-98 and identifies the elements within the overall bill that were responsible for the main changes in price. After early price rises, prices began to fall from 1994 onwards. Prices rose steeply in the first year but then fell slightly in the next four years so that by 1994/95, they were about the same as in 1990. In 1995 and 1996, sharp reductions in the distribution charge reduced prices and in 1997, the effective removal of the nuclear subsidy reduced prices still further. From the consumers’ point of view, these price reductions were welcome, but they were only achieved because of reductions in monopoly charges, effectively paid for by taxpayers, and by the removal of the FFL, which was possible because responsibility for nuclear liabilities was shifted from the current to future generations.
Table 2Components of a Bill
90/9191/9292/9393/9494/9595/9696/9797/98
Typical bill (1990=100)100107.0105.0103.597.789.587.281.8
Distribution2525.225.425.625.822.219.318.7
Supply66665.95.85.65.5
Transmission5554.84.74.64.43.5
Total Monopoly Charge3636.236.436.436.432.629.327.7
FFL10.611.811.610.39.88.98.71.8
Total Regulated Charge46.648.048.046.746.241.538.029.5
Generation53.459.057.056.851.548.049.252.3
(Typical bill – Regulated Charge)
Competition in generation failed to reduce generation prices. Generation prices fluctuated but overall, by 1998, were little lower than in 1990, despite reductions of 30-40 per cent in gas and coal prices (generation from gas and coal accounts for about 70 per cent of generation in Britain). These price reductions had partly been kept by generators as extra profits.The price reductions that were passed on only went to consumers that were able to choose their electricity supplier, the medium and large consumers. Medium and large consumers, who may have annual bills in excess of $1m, have the resources, the negotiating skills and incentive to identify and switch to the cheapest electricity supplier or negotiate cheaper terms with their existing supplier.
The Regulator published data that showed how systematic the companies had been in allocating cheap power to consumers that could choose and expensive power to those that could not (Table 3). Given that he had a duty not to allow price discrimination between classes of consumers, it is not clear why he allowed this to occur. He claimed that this price discrimination justified the introduction of retail competition to small consumers. He said that if consumers could choose, they would switch to the cheapest supplier and companies that offered high prices would lose market share and be forced to reduce their prices or go out of business.
Table 3REC Purchase Costs – 1996/97
Average priceQuantity
(p/kWh)(TWh)
Franchise consumers
Coal contracts3.9271.7
IPP contracts3.8428.9
Other contracts3.7134.3
Average franchise purchase costs3.85134.9
Non-franchise purchase costs3.0080.4
Average total purchase costs3.54215.2
Source:Office of Electricity Regulation (1997) ‘The competitive electricity market from 1998: price restraints: proposals’ OFFER, Birmingham.
3.Prices from 1999 onwards
For electricity, Britain is divided into 14 regions, each with a different former monopoly supplier. After mergers and take-overs amongst these 14 suppliers, there are just six remaining companies. There are now about ten companies competing to supply electricity, the six remaining regional companies, British Gas (the former nationalised gas supply company), and a few new entrants. The new entrants have made no impact on the market for small consumers and can be discounted.
The computer systems necessary to allow retail competition for all 25 million British electricity consumers were complex and expensive. The overall cost passed on to final consumers over five years was about US$1.1bn and, three years after competition was introduced, there are still major practical problems with data handling. There are also serious problems of unfair selling practices by competing retail companies. Typically, companies acquire new customers using door-to-door or telephone sales staff. Salesmen are paid by commission only and they therefore have a strong incentive to win new consumers by any means they can. It is no surprise that they have a catalogue of unfair practices, including forging signatures, and targeting vulnerable consumers. These practices should be easy to control and the Regulator has repeatedly penalised companies for failing to control their sales staff.But three years after electricity competition was introduced and five years after gas retail competition was introduced, they are still occurring and the whole process of retail competition for energy has got a bad name with the public as a result.
There were some minimal (ineffective) restrictions on the prices the incumbent suppliers were allowed to charge from 1999-2001, but, basically, from 1999 onwards, retail suppliers have been able to charge whatever the market will bear. Further large reductions in monopoly prices have meant that, overall, prices have fallen somewhat. However, when we look at movements in the wholesale electricity price, it is clear that the introduction of retail competition increased, not decreased the extent to which retail supply companies exploit small consumers.
Since 1999, the wholesale electricity price has fallen by about 35 per cent.However, the price paid by large consumers for generation has only fallen by 20 per cent and the price paid by small consumers has actually increased by 5 per cent. In 1997, the price paid by small consumers for generation was 5.8c/kWh. Now, the published wholesale electricity price is about 2.2c/kWh. The total electricity price for small consumers is now about 9c/kWh, so, arguably, small consumers are now paying nearly 4c/kWh too much for their electricity. This has not become an issue because, overall, electricity prices are falling. There are other services in Britain, such as rail and health care that clearly are failing, so the public is not interested in services that appear on the surface to be working well.
This raises the question why is retail competition not working in the way the Regulator believed it would.The answer is simply that, as a class, small consumers do not have the resources, the interest or the incentive to switch frequently enough to force suppliers to reduce prices. In most countries where retail competition has been introduced, rates of switching have been minimal. In Britain, experience has been rather different and about a third of consumers have switched. The problem is that consumers are either not switching on price grounds or they are unable to identify the cheapest supplier. If consumers do not appear to be demanding low prices, the market is unlikely to offer them.
Most consumers that have switched now buy their electricity as part of a package of gas and electricity from British Gas, the former national monopoly gas supplier. In most areas, British Gas is actually the most expensive supplier in the market.Consumers probably believe (wrongly) they are getting a good deal from British Gas but, for such an important purchase as electricity, they also want to deal only with a tried and trusted supplier.
4.The role of pre-payment meters
4.1PPMs in a privatised monopoly market
Pre-payment meters have played a key role in protecting (or at least appearing to protect) poor consumers since privatisation. After its privatisation, British Gas adopted a much tougher stance towards consumers that could not pay their bills, and the number of consumers cut off increased markedly, bringing the process of privatisation into disrepute. To avoid this recurring with the electricity industry, a new type of pre-payment meter operated with ‘smart cards’ individual to each consumer was introduced for consumers with difficulty paying their bills.
The smart cards recorded the account details of the consumer and could be recharged at designated local outlets, such as shops. This system is quite complex and while the retail companies did have the advantage of being paid in advance for their power, the cost of the extra infrastructure (the new meter and the connections at shops) was significant. The Regulator capped the extra cost that could be passed on to PPM consumers requiring that PPM consumers pay no more than about 5 per cent more than standard rate consumers. This did not concern the retail supply companies because any costs not recovered from PPM consumers could be spread amongst other franchise consumers.
If the consumer had accumulated debt, some of the money paid by the consumer to charge the card went to paying off the debt. For poor consumers, there were significant advantages with this system. They could continue to receive a supply of electricity even if they had accumulated debt with their electricity supplier. They also did not need to fear receiving a bill of unpredictable size once a quarter. This was a useful advantage particularly for those pensioners that did not heat their dwellings adequately because of the fear of receiving a bill they could not pay. Of course, if they really could not afford their bills, a PPM does not help them. Nor do PPMs address the underlying problem of poverty.