April 2011 Issue #74
UK Retail Energy Markets at 21
UK competitive energy markets turn 21 this year, and Ofgem, the energy regulator, has greeted this coming of age with another competition review and proposed market reform. In this article MJMEnergy's Business Development Director, Nick White, analyses the success of UK retail energy competition and considers Ofgem's latest reform proposals.
In 1990 the British energy industry launched into a new, and fairly unprecedented reform - the establishment of supply competition in both gas and electricity markets, as well as the wholesale restructuring of the electricity industry, with the establishment of 15 separate regional electricity companies (RECs), an independent transmission company for England and Wales, and division of the state's power generation business into NationalPower (now RWE Npower), Powergen (EON UK) and Nuclear Electric (British Energy). Further reforms continued with the gas Network Code in 1996, full retail competition for gas and electricity in 1998 and 1999 respectively, and the New Electricity Trading Arrangements in 2001. Britain's retail energy markets are often described as the most competitive in the world, and the UK NBP gas hub has become the major gas trading market outside of North America. However, recent announcements of a retail energy market review and electricity market reform have called into question both the health and the suitability of parts of the system. This article provides a brief review of the UK retail energy market at 21 and outlines some of the proposed reforms.
Success of the market
How do you measure the success of a competitive energy market - a number of different ways have been used over the year. In this analysis we focus on the areas of market-share, switching, prices, and new entry.
In market-share terms energy competition in Britain seems to have been largely successful. In the large customer market the former monopoly suppliers - British Gas (Centrica) and the successors to the RECs - are now only one of a number of players, and indeed tend to be comparatively small in this sector. In the domestic and small business market there are six main competitors ('The Big Six') - British Gas and the former REC businesses now owned by RWE Npower, EON UK, EDF Energy, Scottish and Southern Energy (SSE) and ScottishPower. From a supply monopoly, British Gas' domestic gas market-share has fallen to around 43%, while similar falls have been observed for the former RECs in their local areas.
Ofgem's surveys indicate that 41% of domestic gas customers and 40% of domestic electricity customers have switched supplier at some point, in 2010 switching levels were estimated to be 17% and 15% respectively. In relative terms these are high levels, and compare very favourably with most European markets, as well as other examples of retail energy market competition in North America and elsewhere.
Competitive energy markets are intended to bring competitive pressure to bear on prices, so all other things being equal, should lead to lower prices than non-competitive markets. This picture is greatly complicated by a range of other facts, including wholesale market prices and contract structure, and taxation. Nonetheless UK energy prices remain at the lower end of the EU scale. The figures below compare prices including taxes across the EU. Although the latest complete data is from early 2010, roughly the same position remains.
Another sign of a competitive market is the ease with which new entrants can enter the market. Here the success of the UK market looks somewhat more questionable. On the domestic energy side the Big Six hold over 99.5% of the market between them, and although three are owned by German or French companies, they have all built their position by buying up the customer portfolios of RECs, the former regional monopolies. Although there have been some more market entrants in recent years such as OVO Energy, First Utility, EBICO, Good Energy and Spark Energy, they remain very small, between them supplying less than 0.5% of the domestic market, and tend to be niche players focusing on green or ethical supply, smart meters, supply to landlords or other niche markets. There has not yet been a large-scale market entry by a major league energy business without the security of purchasing an existing customer portfolio.
So what's the problem?
The key problems with the market in Ofgem's perspective appear to be that competitive pressures in the market are decreasing, as evinced by declining switching rates and 40-60% of customers who are considered to be "sticky" - unlikely to be switch suppliers and therefore likely to pay higher prices. In particular a large number of these customers purchase fuels separately - gas from British Gas and electricity from the former REC - and tend to pay a comparatively high price for each. Competition is not deemed to be working in the gas only and electricity only markets, with the dominant supplier retaining up to 80% of this market. Ofgem identifies market complexity as a factor disincentivising customers to switch, with over 400 different tariffs available in the market, it may be difficult for customers to choose the best tariff for them. Market liquidity is also an issue in the electricity market, making it difficult for new entrants to enter the market and secure reasonable power supplies at a reasonable cost. This is exacerbated by the increasing vertical integration of UK electricity generators and suppliers. All of the Big Six are significant power generators, and the UK electricity trading market has lost liquidity in recent years, making it a more difficult place for new entrants to source and balance electricity supplies.
The evidence of all this for Ofgem seems to be crystallised in the strengthening margins it has calculated for the Big Six energy suppliers. Through much of the 2000s margins were thin for domestic energy suppliers, particularly in dual fuel, and the majority of their retail revenue came from their former monopoly customers on more expensive tariffs. Since the steep prices retail rises in 2008 margins have appeared much better and Ofgem has now conducted analysis that it believes shows suppliers put up retail prices more quickly in response to rising wholesale costs, than they reduce them when wholesale costs fall. For Ofgem this a clear sign of competition not working as it should, and in its March 2011 Retail Market Review, it has proposed a number of remedies.
Proposal 1: Improve tariff comparability
Make it far easier for domestic customers to compare tariffs and choose a better deal
With over 400 tariffs available in the market, choosing the right one can be complex (although it also should be said that price comparison websites do run detailed comparisons). Ofgem proposes to require each supplier to offer a single standard evergreen tariff, simply expressed, for each of the payment categories. Suppliers may offer other tariffs, but only a fixed-term basis. This is intended to make it much simpler for customers to compare tariffs and hopefully encourage the sticky customers to make a move. Currently 75% of customers are on standard evergreen contracts.
Proposal 2: Enhance liquidity
Improve access to wholesale market products for new entrants and independent generators and suppliers
This proposal is intended to mitigate the effect of the vertical integration of the Big Six, proposals both to require the Big Six to offer 10-20% of their generated power in Mandatory Auctions, and to create Mandatory Market Making to make it easier for small players to trade at any point. This is proposal is under consideration as part of Electricity Market Reform, and has similarities with the Virtual Power Plant auctions that have been carried out in France and Germany to encourage competition.
Proposals 3 and 4: Strengthen Probe remedies in domestic and non-domestic markets
In its Energy Supply Probe of 2008 Ofgem imposed a number of remedies on energy suppliers in both the domestic and the non-domestic (particularly small business) sector. Although there have been some improvements in these areas, in particular in reductions in price differentials between different payment methods, there remain significant issues which Ofgem now proposes to prosecute more zealously, possibly with further licence condition amendments.
Proposal 5: Improve reporting transparency
Following the Probe, vertically integrated suppliers were required to publish transparent accounts for their energy supply business, to improve regulatory and public oversight of their profit margins. Ofgem is now proposing tightening up these requirements.
Will it work?
When asked what he thought about companies making large profits, Winston Churchill is reported to have replied that he preferred it to the alternative. Overall UK retail energy markets have proven successful and in general prices to consumers are comparatively low. However, there are clearly sectors of the market where competition is not working very effectively, with the 40-60% of the market so-called sticky customers. Proposals that aim to increase their engagement with the energy market may be admirable, and indeed, with these customers typically paying perhaps £100-200/year more than they might do on the most competitive tariffs, should be of interest to consumers. Nonetheless, Ofgem, and the energy industry, may need to face up to the fact that buying cheaper energy is just not that interesting to most customers, and efforts to encourage switching in these sectors may be doomed to failure. As the old saying goes, you can lead a horse to water but you can't make it drink.
MJMEnergy's UK Gas Markets and UK Electricity Markets courses provide detailed understanding of these complex industries. The next UK Gas course is on 26th April at Lord's Cricket Ground, London, and UK Electricity on 4th May at Lord's. For more information visit http://www.mjmenergy.com
 It should be noted that some of the low prices, particularly in the countries of Eastern Europe, are due to cross-subsidization of prices, rather than effective competition.
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