|Issue Number: 109||June 2014|
The Big Six: A Sense of Vertigo?
Earlier this year, Ofgem published an important report called 'State of the Market Assessment'. This report was significant because it identified that 'competition is not working as well as it could' in key parts of the energy market. There is now a consultation on referring the matter to the Competition and Markets Authority (CMA), and a decision ought to be published shortly. The CMA is a newly-established organization that has taken over from the Competition Commission and Office of Fair Trading. The CMA is responsible for increasing competition in businesses and reducing anti-competitive activities, and it is expected that there will now be more competition cases in the regulated sectors with more enforcement and quicker throughput of the cases.
Although Britain's retail energy markets have been described as the most competitive in the world, British consumers do not, in general, share this sentiment. In recent times, there has been increasing discontent of energy companies and it has been an important driving force behind the recent competition report. Although the report considers several areas of the market where competition has been possibly limited, a key area was related to the issue 'vertical integration'. This term refers to the level of ownership possessed by an energy company over all essential aspects of the supply chain in the industry in which it operates, such as owning or controlling generating facilities, transmission facilities and distribution lines. Vertical integration is a controversial issue because whilst some see it as an essential feature of a functioning energy market, others see it as a barrier to competition.
This article will examine the origins of vertical integration, its current nature, and how it may be affecting levels of competition in the energy market.
Brief history of vertical integration in the UK
Before competition was fully introduced into the retail energy markets in 1999, British Gas and the 14 regional Public Electricity Suppliers (PESs) had a monopoly to supply all domestic gas and electricity consumers. Since 2001, the electricity sector in the UK became progressively more vertically integrated, with the largest six energy supply companies increasing their ownership of generation capacity. Then over the following five years, the number of suppliers fell to six as a result of horizontal mergers. Some of these businesses also merged with generation companies to create vertically integrated firms. From 2000, the six largest suppliers' ownership of generation capacity has increased from 36% to about 70% in 2013. This has been driven mostly by acquisitions; for instance, EDF acquired British Energy in 2009.
How can vertical integration strengthen security of supply?
Responding to Ofgem's report, Centrica said that 'vertical integration is in the interests of customers, promoting security of supply and helping protect customers from volatile price movements.' Is there any truth in this?
There is little doubt that vertical integration can put a firm in a stronger financial and market position. There are lower collateral requirements when buying from the electricity market for firms that have stronger credit ratings. As EDF has noted, when it trades bilaterally over the counter with counterparties, it is given a collateral-free credit line because of its investment grade credit-rating. This is something that smaller energy firms are simply unable to do.
Do benefits filter down to customers? Indirectly, it does have significance because a firm that is in a strong financial position will mean that there is less risk of it failing; meaning that security of supply is strengthened. Whilst an independent supplier may be vulnerable to changes in the value chain, a vertically integrated supplier can absorb shifts in upstream and downstream margins without their retail markets being affected. In a more direct way, vertically integrated firms have a strong security of supply because they are able to meet more of their own generation needs themselves without needing to trade so extensively on the wholesale market. As figure 1 shows, four of the Big Six have sufficient generation to more than cover their demand for domestic and small business customers, with the other two not far behind.
Figure 1: Aggregate balance between GB electricity demand and supply for the six largest energy supply companies for 2012 (TWh). 
However, with the big energy companies depending less on the wholesale market, it has been suggested by small suppliers that there is subsequently less liquidity on the electricity market. This poses a problem to small suppliers because they believe it is harder to access the products they need in the electricity wholesale market and serves as a barrier to expansion. According to Ofgem, it is this area that independent suppliers felt particularly disadvantaged when compared with the larger suppliers. The largest suppliers are able to rely on their internal generation for short and long-term products, whilst this is not an option with smaller providers. Ofgem describes it as a 'vicious circle': with the Big Six replying on internal generation, they no longer look to the wholesale market; thus reducing liquidity in the market. Consumer Focus, a consumer group, has morbidly referred to this as the liquidity 'Graveyard Spiral'.
Figure 2: the Liquidity 'Graveyard Spiral'
Correlation does not imply causation… or does it?
This begs the question, is there a connection between low wholesale market liquidity and the vertical integration of energy firms? The Big Six say no, whilst consumer groups and small suppliers say yes. In general, the Big Six largely consider that the levels of liquidity in the wholesale market as sufficient and that the question of vertical integration is completely unrelated. On the other hand, small companies believe that the low level of liquidity is a direct result of the vertical integration of the Big Six. They think that limiting the degree of vertical integration would improve liquidity in the market.
All things considered, it is reasonable to suggest that vertical integration is partly responsible for the low levels of liquidity on the wholesale market. If the Big Six are able to generate their own electricity when there are unexpected changes in demand, then there is less incentive for them to adjust their wholesale position as often. Additionally, the Big Six's churn rations are on average below the ratio of other European wholesale markets. The churn ratio is the ratio of traded volume of a commodity to physical output or consumption of the traded commodity. As figure 3 shows, liquidity in the GB electricity market has fallen from a high of around 7 in 2002 to around 3 in 2013.
Figure 3: Wholesale electricity: overall volumes traded and degree of churn.
What is the impact of the lack of liquidity for smaller suppliers?
Where there is less liquidity on the market, prices can be more volatile and could increase the prices paid for electricity by those dependent on the market. There is also the possibility of market manipulation by vertically integrated firms: if these firms have enough market power, then they could raise prices directly or withhold generation capacity to achieve price increases. However, the evidence is not clear whether any of the firms actually have the capacity to raise wholesale prices through withholding capacity. This is a burning issue that only the CMA can fully investigate. In the meanwhile, Ofgem has pledged to initiate liquidity reforms.
The nature of the Big Six as vertically integrated firms and its relevance for the state of competition in the energy market is an unresolved issue. This article has suggested that there are reasonable indications that the growth of vertically integrated firms has led to a lack of liquidity on the market, thus having an impact on smaller suppliers. Due to the lack of access to the products they need, and having to potentially pay more for these products, the growth of smaller suppliers has been subsequently limited. They are also less likely to be as competitive on price as the Big Six.
The cost of electricity in the UK is one of the cheapest in Europe. Perhaps with more liquidity in the market, accommodating and encouraging greater competition from smaller suppliers, energy prices could be even cheaper. More will be clear in the future as the CMA is likely to investigate the vertically integrated nature of the Big Six.
In the meanwhile, there are signs of change at Ofgem. The new CEO of Ofgem, Dermot Nolan, has said in front of the Energy and Climate Change Select Committee the regulator will take a 'more aggressive approach' to resolving issues in the energy market. Consumers and small energy suppliers are waiting with bated breath.
Researched and written by MJMEnergy Analyst, Nico Cottrell,
 For more information on this, see 'State of the Market Assessment', p. 88.