Why retail electricity competition is bad for small consumers: British experience

Presentation to the international conference
Restoring Just and Reasonable Electricity Rates

Washington DC: 28-29 September 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
Email: Stephen.thomas@gre.ac.uk

Why retail electricity competition is bad for small consumers: British experience

1. Introduction

For most products, to suggest consumers would be better off served by a regulated monopoly than by a competitive market would be a heresy, but for electricity, experience in Britain suggests that this would indeed be the case. There are four main reasons for this:

• Competition is not a ‘free good’. Introducing competition imposes a range of additional costs that must be paid by consumers. In the case of electricity, these costs are very high and it is far from clear that the benefits will outweigh them;

• Retail electricity competition will result in a transfer of costs from large to small consumers because large consumers have the incentive, negotiating skill and resources to get the best deal from the market;

• Within small consumers, it will be the poorest consumers that do worst because competing retail suppliers will target rich consumers who consume more and who will be more likely to buy other services that their electricity company offers; and

• The breaking down of monopoly territories is already leading in Europe to a rapid concentration in the sector so that it is dominated by only a handful of companies that have no incentive to compete hard against each other.

In a well-regulated monopoly electricity system, electricity companies generally have little incentive to discriminate between classes of consumer: they are required to supply all consumers. In some cases, it may be possible to lure a large user to locate within their service region and this may cause them to offer uneconomic rates, but generally they should allocate costs fairly. This is not to say cost allocation was always perfect in monopoly systems. Cost allocation in a network system with a standard product will never be a precise science and governments often intervened, sometimes to ensure energy intensive industries got low prices so they would be competitive and sometimes to ensure small consumers had access to power at low costs. A competitive industry has a systematic incentive to favour large over small and rich over poor.

2. Wholesale electricity markets

This paper focuses mainly on retail competition in electricity, that is, allowing consumers to choose the company they buy from. However, it is worth briefly discussing developments in wholesale markets. It was the promise of wholesale electricity markets that is driving the reforms of electricity industries. Generation is much the largest element of an electricity bill and, it was reasoned, if generation could be made competitive, costs would be forced down. In practice, designing efficient wholesale electricity markets has proved difficult. In California and Brazil, markets spectacularly failed while in Britain, the Power Pool, model for reforms all round the world was abandoned in favour of a much less ambitious design, the New Electricity Trading Arrangements. If we take as our criteria that the market should force prices down to the long run marginal cost level and that the market should provide adequate incentives to allow sufficient investment to ensure security of supply, it would be hard to argue that there is a proven market design. It is fashionable to emulate the PJM design, but it remains to be seen whether this design really will be able to cope with the full range of conditions it will have to face.

The dilemma may be that a design that is truly competitive may be too risky to allow investment, while a design that allows investment would not be competitive. In Britain, the problem has been sidestepped by allowing integration of generation and retail supply. Generators now generate electricity to supply their own consumers, using the power exchanges only for marginal purchases and sales. Such power exchanges may be useful way to balance supply and demand at low cost, but they are hardly likely to give reliable investment signals. Essentially, this type of vertical integration relies on consumers doing the job the wholesale market was expected to do: by switching frequently to the cheapest supplier, consumers would put competitive pressure on generation.

3. The costs of competition

There are inevitable costs of competition, for example, duplication of competing facilities and lost scale economies and, in the immediate post World War 2 period, these factors (along with the obvious technical factors) meant that many governments believed that nationally-owned monopoly electricity companies were the most efficient way to organise their electricity industries.

For most goods, the costs of competition are low and the benefits clear, but for electricity, while the rhetoric of competition is powerful, the benefits are far from clear and the costs substantial.

In theory, the benefits of retail competition can only be small. The largest element of an electricity bill (typically more than 50 per cent) is generation and if generation is an efficient market, it should not be possible for one supplier to buy power much more cheaply than another. About 30 per cent of the bill is monopoly charges for use of the transmission and distribution networks and, in a well regulated system, these charges should be the same for all suppliers. This just leaves the suppliers’ own costs to compete over, mainly meter reading, data processing and billing, hardly the basis for major price reductions.

The costs are diverse. The inevitable companion of competition is risk and this has a dramatic effect on the cost of capital. In Britain, the National Grid Company survives very comfortably on an allowed real rate of return of 6.25 per cent. New power stations must achieve a 15 per cent real rate of return, reflecting the riskiness of investment in power plants when the company does not have a firm agreement to sell the output of the plant at a profitable price. In a capital intensive industry such as electricity, this is bound to have a dramatic effect on costs.

One of the lessons of reforms so far is that transmission networks have to have a substantial amount of spare capacity if generators are not going to exploit potential congestion charges. This capacity must be paid for by consumers.

However, the most obvious costs are those required to run the markets. When retail competition was introduced for small consumers, the cost that would be passed on to them over a five-year period was found to be £730m, about £30 per consumer. The costs of developing NETA have not been properly estimated yet, but they are expected to be in the region of £600m and running costs are £80m per year, about £40 per consumer over five years. Much of the complexity of NETA arose because of the need to allow small consumers to switch supplier.

4. Discrimination between small and large consumers

4.1 The Process

In Britain, competition was phased in over 9 years. The 5,000 largest consumers (those with a maximum demand of more than 1MW) were given choice immediately after privatisation in 1990. There were serious practical problems related to metering and data processing but these were solved over the first year and since then, large users appear to have been able to use the market successfully. Choice was extended to 50,000 consumers (those with maximum demand over 100kW) in 1994 and again after serious practical problems, medium-size consumers appear to be using the market to their advantage. Typically, medium and large consumers sign yearly contracts for power and a large proportion switch supplier or renegotiate better terms with their existing supplier.

In 1998, choice was to be extended to all consumers. Again, practical problems arose and the process was not completed until over a year late. As noted previously, the costs were immense. Since privatisation, medium and large consumers have clearly done well from competition, but the issue is whether there has been a net benefit from greater efficiency or whether it is a ‘zero sum game’ with costs being transferred from large to small consumers. The evidence is strongly that it was the latter, despite the Regulator having a duty, at least till 2001, not to allow discrimination between consumers.

4.2 Experience to 1998

In 1997, when small consumers were still captive to their local supplier, the Regulator published data that showed that small consumers were paying about 30 per cent more for the generation element of their electricity than consumers that could choose. Retail supply companies were systematically allocating their expensive purchases to the captive market and their cheap purchases to the competitive market. At that time, generation costs represented about 50 per cent of a typical household electricity bill, so if costs had been fairly allocated, small consumers bills would have been about 5 per cent lower and large consumers’ bills about 10 per cent higher (generation is a higher proportion of large consumers’ bills).

Table REC Purchase Costs – 1996/97

Average price Quantity (p/kWh) (TWh)

Franchise consumers Coal contracts 3.92 71.7 IPP contracts 3.84 28.9 Other contracts 3.71 34.3 Average franchise purchase costs 3.85 134.9
Non-franchise purchase costs 3.00 80.4
Average total purchase costs 3.54 215.2

Source: Office of Electricity Regulation (1997) ‘The competitive electricity market from 1998: price restraints: proposals’ OFFER, Birmingham.

The Regulator cited this data as evidence of the need to allow small consumers to choose, suggesting that if there was choice, small consumers would switch to cheap suppliers and retail suppliers would not be able to continue this discrimination. He did not explain why he allowed the companies to behave in this way, in apparent conflict with his statutory duties.

4.3 Experience after 1998

The idea that small consumers would have the resources, incentives and interest to regularly change their electricity supplier always seemed unrealistic and in most countries where small consumers have choice, switching rates are low (10 per cent or less). In Britain, small consumers can now choose from the six remaining integrated generation and retail supply companies and British Gas. No new entrants have won any significant market share. About a third of small electricity consumers have switched, but nearly all those switching has chosen to buy gas and electricity as a package from British Gas, the most expensive supplier in the market. It appears that while consumers may believe they are getting a good deal from British Gas, they also value buying such an important commodity from a tried and trusted supplier.

The message for electricity suppliers is clear. Small consumers are generally not interested in shopping around; hence all companies in the retail electricity sector except for British Gas acquired their businesses by buying the former monopoly retailers, paying up to £200 per consumer. Given that the profit level to a retailer on a typical consumer is probably no more than £20-30 per year, it is clear that companies assume that most consumers will never switch supplier and that, in addition to electricity, it will be possible to sell their consumers a range of other, more profitable services.

Small consumers generally do not have the resources to identify the cheapest deal, and they are influenced by other factors such as brand loyalty. The obvious strategy for the integrated companies is to keep prices high and not provoke a price war. This strategy is graphically illustrated by the movements in prices since 1999.

The wholesale electricity price has fallen by 35 per cent since 1999. While this may appear to be a good thing for consumers, none of this price reduction has been passed on to small consumers. While the wholesale price has fallen by 35 per cent, the price large consumers pay for generation has fallen by 22 per cent while the price paid by small consumers has actually increased by 5 per cent. The integrated generation/retail companies have simply transferred costs from generation to the retail supply element of the bill and the overall price paid by small consumers remains largely unchanged. This strategy has a number of advantages other than maintaining the integrated companies’ high profits in the residential sector and has cost them nothing. It appears to show to the Regulator that the generation market is now finally competitive and it also forces the non-integrated generators, who have seen their income fall by 35 per cent, out of the market.

So competition seems to have been a bad thing for small consumers. If price reductions in the wholesale market had been passed on, the overall price small consumer pay for their electricity would be about 30 per cent less than it actually is. It might be expected that in the face of such blatant exploitation there would be serious public concern. The problem is that prices of electricity are falling, driven by regulatory reductions in monopoly prices and, understandably, the British public is more concerned about services that blatantly are going wrong, such as the rail system, rather than one which is still delivering a reliable service at falling prices. The Regulator, having promoted the introduction of competition is unlikely to now admit it was a mistake, while consumer groups have been to keen to continue to preach the virtues of competition.

5. The impact on poor consumers

5.1 Fuel poverty in Britain

Fuel poverty is defined as when more than 10 per cent of household income is spent on fuel. About 20 per cent of UK households fall into this category. Fuel poverty generally has two aspects: the first is low household income and the second is inefficient and expensive heating systems that the occupant does not have the resources or the capability to improve.

It is this second attribute that distinguishes fuel poverty from poverty in general. It has also tended to be the more difficult aspect of the problem to address because of the difficulty of devising equitable programmes to improve the quality of the housing stock. However, the measures to liberalise electricity markets introduce new risks for poor consumers, which may mean that, for the poorest people, the problems could become even more intractable.

In a competitive electricity market, the trend in Britain and elsewhere in Europe has been for electricity retailers to offer their consumers a range of household services. For example, British Gas offers gas, electricity, telecoms, a credit card, insurance, financial services and roadside breakdown recovery. Selling just one commodity to a consumer is probably not very profitable but a package, where prices of individual services can easily be disguised can be much more profitable. For such a strategy to work, the company needs to be able to target effectively richer consumers who will have the resources to buy such a package. This means that the poorest consumers are inevitably not going to do well from the introduction of competition because competing companies will have no incentive to supply them.

5.2 Pre-payment Meters

Pre-payment meters (PPMs) have played a key role in protecting (or at least appearing to protect) poor consumers. 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 newsagents. 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 the consumer, there were significant advantages with this system. They could continue to receive a supply of electricity even if they had not paid their bills. They also did not need to fear receiving a bill of unpredictable size once a quarter. This was a useful advantage particularly for pensioners who did not heat their dwellings adequately because of an unjustified fear of receiving a bill they could not pay. Of course, if they really could not afford their bills, a PPM did not help them.

PPMs also had an important advantage for retail electricity supply companies. They did not incur the expensive and politically damaging cost of cutting off consumers that could not pay their bills. Consumers that could not pay their bill disconnected themselves. The extent of the fuel poverty problem was masked. There is no ready way to determine how many consumers are disconnecting themselves. Survey work is now carried out to determine the extent of the problem, but the accuracy of this work is questionable as consumers may be too proud to admit their financial difficulties.

Nevertheless, PPMs have proved popular with consumers and now about 15 per cent of consumers pay by this means. They may well be aware that they are paying a higher price for their power, but, in the same way as pre-payment mobile phones are popular despite high call charges, they value the extra control over tight household budgets that the PPM gives them.

5.3 A practical example

To overcome the problem of the difficulty of comparing the various offers, the Regulator and the consumer watchdog (Energy Watch) publish charts on the internet that allow easy comparison of prices.[1] These are good but do require consumers to know they are there and be confident of navigating the web. Few consumers are aware of these comparisons and many consumers do not have the skills or the resources to access them. It is also worth noting that these price comparisons change frequently and a consumer choosing the cheapest supplier might find a month later that they no longer have a good deal. All major electricity suppliers also try to sell gas as well as electricity in a so-called dual-fuel offer

There are three ways to pay gas and electric bills in Britain.

• By Direct Debit (DD). These are the most attractive consumers for competing suppliers to target. They have an orderly bank account (a surprisingly large number of people in Britain do not have a bank account, much less one that would allow them to put use DDs) and are probably rich enough to want to buy other services provided by the company.

• Quarterly in arrears. This is the normal method.

• Pre-payment meter (PPM). Consumers that have difficulty paying their gas or electricity bills have little choice but to install a PPM.

There are other less obvious barriers for poor consumers. All licensed gas and electricity suppliers are obliged to offer a supply at the posted prices to any consumer that requests it. However, the supplier can ask for a cash deposit of any size. They might do this if a consumer has a poor payment record or has unpaid debts. If a company does not want a new consumer, it can simply ask for a prohibitive deposit. So even where PPM consumers could make savings in theory, in practice these savings might not be achievable. A consumer that cannot afford their electricity bill is hardly likely to be able to find a deposit of, say, £200.

To illustrate the choices that face small consumers, let us look at a consumer in London (other regions would show the same picture) using average amounts of gas and electricity. For a consumer that does nothing, i.e., he or she continues to buy electricity from London Electric and buy gas from British Gas, the following prices would apply (before tax). The cheapest offered price is in brackets (excluding very small companies).

Table Prices for consumers in London that do not switch

DD Quarterly PPM
Gas 314 (271) 347 (288) 347 (322)
Electric 236 (214) 247 (223) 255 (244)
Total 550 (485) 594 (511) 602 (566)

If this consumer were to switch to a dual fuel offer, the results would be:

Table Dual fuel offers for an average consumer in London

DD Quarterly
British Gas 522 566
London 510 533
Best (npower) 482 518
Worst British Gas British Gas

The following factors emerge:

• Even for consumers that do not switch, PPM consumers pay nearly 10% more than DD consumers;

• There is no saving to be made by taking a dual fuel offer compared to buying electricity and gas separately from the cheapest suppliers;

• Despite being the most expensive supplier in the market, British Gas is the only company in the electricity market gaining significant market share;

• Savings achievable from switching for DD and quarterly consumers are about 12%, whereas for PPM consumers, the best saving (not necessarily achievable) is about 6%.

In short, consumers that are rich and smart will pay 20% less than a PPM customer and can reduce their bill by about 12%. Whether many such consumers are likely to go to much effort to make a saving of perhaps only £6 per month is questionable.

6. The trend to oligopoly

In Europe, the opening of electricity markets has led to a massive wave of restructuring as previously protected monopolies are bought up by a small number of aggressive players. Already, the market is dominated by three large companies, EDF of France, and RWE and E.ON of Germany. A second layer of companies, such as Vattenfall, ENEL and Endesa has market power in some of the regions. These companies were the main national companies in their home territories. It seems when governments were faced with the apparent choice of breaking these companies up to create a competitive field, or leaving them intact so they could use their profitable home base to make foreign acquisitions, they chose the latter. In Britain, the government chose the former and the privatised electricity companies have nearly all failed and been taken over. Ironically, as noted above, Britain still does not enjoy a truly competitive electricity market.

The position of the European Commission is even more paradoxical. It introduced a measure, the Electricity Directive, that was apparently intended to break up monopolies and introduce competition, yet they are standing by as the market falls into unregulated oligopoly, arguably a far more dangerous position than a regulated monopoly. A typical response when questioned on this is ‘Many markets are oligopolies; we (the Commission) know how to deal with them.

US companies appeared likely to have an impact on European markets in the late 90s, but it seems they had neither the skills, nor the ambition to develop new markets in Europe. Now companies such as NRG, Mirant, Reliant and Entergy are in full retreat from Europe and other foreign markets.

The fate for Europe seems to be sealed; there is neither the political will, nor the commercial muscle to take on these giants. It remains to be seen whether these companies can achieve the global dominance that the giant oil companies have achieved, but they will undoubtedly acquire one of the skills of the oil companies very quickly: convincing the public they are in a competitive market, when the reality is very different.

7. Conclusions

The introduction of retail competition for small electricity consumers has been an economic disaster for small consumers in the UK. It has opened the way to exploitation small consumers and bad treatment of poor consumers that would never have been tolerated under the old monopoly system. Those that have the power to do something about the situation, government and the regulatory bodies are all compromised by their involvement in the reforms and it will be some time before effective changes, which will inevitably require stricter regulation and greater government involvement, will be politically feasible.

Turning the clock back to the days of national and regional monopolies is not an option for most countries now. The challenge will be to develop a new organisational model for the industry that has the advantages of control that the old centralised systems had, but that does not suffer from its stifling inflexibilities.

Table British Electricity Industry Structure – 1990 and 2002

1990 2002
Generation (Capacity GW)
National Power 30 British Energy (heavy losses) 11.6
Powergen 20 *Innogy (RWE) 8.0
Nuclear Electric 8 *Powergen (E.ON) 7.4 *Scottish Power (merger with S&S?) 5.0 *EDF 5.0 AES (kept solvent by junk bonds) 4.8 AEP (2GW for sale) 4.0 *Scottish & Southern 3.8 *TXU (1.2GW mothballed) 3.0 BNFL (huge losses) 2.7 Edison Mission 2.4 *British Gas 1.5 I’national Power (.5GW mothballed) 1.5

Distribution
1. London
2. Eastern
3. Seeboard *1. EDF
4. SWEB
5. SWALEC 2. The Southern Co (USA)
6. South Scotland (Scottish Power)
7. Manweb *3. Scottish Power
8. North Scotland
9. Southern Electric *4. Scottish and Southern
10. Norweb 5. North West Water
11. Yorkshire
12. Northern 6. Mid-American Energy Holdings
13. East Midlands *7. Powergen (E.ON)
14. Midlands 8. Aquila (USA)

Retail supply
1. London
2. SWEB
3. Seeboard *1. EDF
3. Eastern
4. Norweb *2. TXU
5. South Scotland (Scottish Power)
6. Manweb *3. Scottish Power
7. North Scotland
8. SWALEC
9. Southern Electric *4 Scottish & Southern
10. Yorkshire
11. Midlands
12. Northern *5. Innogy (RWE)
14. East Midlands *6. Powergen (E.ON)

Transmission
NGC (owned by RECs) NGC (independent)

* Companies with generation and retail supply
Table Models of Electricity Systems
| |Ideal |Reality |
|Monopoly system |Economies of scale minimise costs. |Lack of control over costs with consumers left to foot the bill. |
| |Avoidance of wasteful duplication of facilities. |Overinvestment to minimise any risk of power shortages. |
| |Ability to achieve wider environmental, social and macro-economic objectives. |Social and economic measures became fossilised and cease to serve useful purposes. Disruptive |
| |Public accountability. |government interference. |
| | |Technical dominance of utilities makes it difficult for their judgements to be questioned. |
|Competitive model |De-integration and atomistic competition in wholesale and retail markets forces |Vertically integrated oligopolies give an illusion of competition. Creating markets requires |
| |prices down to the long-run marginal cost. Competition is a ‘free good’. |huge investment in by consumers in software and high running costs. |
| |Supply and demand balance because overinvestment avoided as a result of market |‘Hog cycles’ of over- and under-investment lead to wasted investment and mean security of supply|
| |discipline. |is put at risk. |
| |Investment risk borne by investors, not consumers. |Oligopoly powers mean extra costs still land on consumers. |
| |Shareholders exert financial discipline. |Shareholder profits come before public service. |
| |Indigenous fuel and equipment industries are forced to become competitive. |Indigenous capabilities are lost, and fuel and equipment are supplied by a handful of |
| |Social and environment policy objectives are decided by central government, not |multinational companies. |
| |utilities and paid for by taxpayers not consumers. |Poor consumers are discriminated against by suppliers and meeting environmental objectives |
| | |becomes difficult. |

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[1] (http://www.energywatch.org.uk/uploads/London_Price_Comparisons.pdf)