Silviase/jgov_v1.4_full_ann huggingface dataset:
appointed by the Minister.

In Scotland, two vertically integrated boards - the South of Scotland Electricity Board (SSEB) and the (smaller) North of Scotland Hydro Electric Board (NSHEB) - generated, transported and supplied electricity to consumers in their respective areas.

### 1.2 Problems under nationalisation

In common with other British nationalised industries, during its period of government ownership electricity was beset with the problems which arise from the absence of competition in the product market and the capital market and from the politicisation of decision-making:

0 because entry to the industry was prohibited, consumers lacked the power of exit. Consequently the various corporations in the industry had little incentive to take consumers' interests into account;

because the industry was outside the market for corporate control, there was no takeover threat to stimulate efficiency improvements. There are bound to be serious agency problems when the ultimate 'owners' of a business are the voting public who have no transferable property rights;

0 the industry’s monopoly in the product market translated into considerable bargaining power for its unions which appeared to secure very favourable arrangements for their members;

0 the politicisation of decision-making meant that managerial objectives were confused by uncertainty over whether ‘commercial’ or ‘public service’ objectives should be given priority. Both investment programmes and prices were influenced (and at times controlled) by government. For example, in the 1970s, a Labour Government persuaded the industry to hold down its prices in an effort to keep down the general rate of consumer price inflation; in the 1980s, a Conservative Government made the industry increase prices to reduce public borrowing.

A succession of White Papers on the nationalised industries (in 1961, 1967 and 1978), which dealt with economic and financial targets and relations with government, did little to help. Well-meaning pronouncements, such as those in the 1967 White Paper - the injunction to price on the basis of long run marginal cost and to adopt test rates of discount similar to those used for low-risk private sector projects - were over-ridden by the political calculus, by a lack of will in the nationalised corporations and by the practical difficulties of applying such concepts. $ ^{2} $

Moreover, the electricity supply industry became the principal support system for the
nationalised British coal industry. $ ^{3} $ From 1957 onwards, as British coalmining went into decline - because oil and gas prices declined relative to the price of indigenous coal and consumers substituted those fuels for coal - governments began to protect the industry from competition. The dominant method of protection came to be government pressure on the nationalised electricity industry to burn more coal than it would freely have chosen. From 1979 onwards, previous arrangements were formalised into a series of government-brokered 'Joint Understandings' under which the nationalised electricity supply industry agreed to take nearly all its coal (at that time nearly 90 million tonnes a year) from the nationalised coal industry.

The electricity supply industry was also used to support two programmes of British-designed nuclear power stations, the first (Magnox reactors) beginning in 1955 and the second (Advanced Gas Cooled Reactors) beginning in 1965. It provided more general support for British industry, for example through its 'Buy British' policy for generating plant. The electricity industry under nationalisation therefore became an instrument of government energy policy and government industrial policy. $ ^{4} $

### 1.3 The transition to privatisation

The difficulties which arose under nationalisation are significant partly because they influenced the privatisation scheme but also because they established a starting point from which the changes brought about by privatisation occurred. Removing the constraints of government ownership from an industry which had been more affected by them than most - and which had been an instrument of government policies for over thirty years - was bound to have drastic effects on employees, on consumers and on associated industries.

By the late 1970s, there was a widespread perception that nationalisation British-style had not worked well. $ ^{5} $ Proposed remedies varied, from tighter state control to denationalisation. But, given the change in intellectual climate in the late 1970s and 1980s towards a belief in greater reliance on markets, $ ^{6} $ and given the election in 1979 of a Conservative government under Mrs Thatcher determined to reduce the role of the state, the denationalisation approach prevailed. From 1981
onwards, the Thatcher governments began to privatise state corporations nationalised by Attlee or subsequently. $ ^{7} $

These moves were at first tentative, denationalising industries already in competitive markets (such as Cable and Wireless, Amersham International, Britoil, Enterprise Oil and Jaguar). $ ^{8} $ Then in 1984 came Britain’s first privatisation of a major utility when 50 per cent of the shares in British Telecom were sold to the public. The political success of this privatisation - in terms of the widening of share ownership it achieved, the revenue it raised, the favourable media publicity it attracted, and the subsequent boost to the government’s popularity - made it a landmark in the privatisation programme. From then on, the government was keen to proceed speedily with privatisation of the other utilities.

In 1986, British Gas was privatised in another politically successful move, though gas privatisation - which left the privatised British Gas Corporation as a very powerful incumbent - was heavily criticised by some economists. $ ^{9} $ Soon afterwards, electricity privatisation moved on to the political agenda: the Conservative Party’s election manifesto of May 1987 promised to ‘…bring forward proposals for privatising the electricity industry subject to proper regulation’.

### 1.4 The electricity privatisation scheme

The privatisation scheme was explained in two White Papers of February and March 1988 - one for England and Wales and the other for Scotland. $ ^{10} $ Under privatisation, as under nationalisation, there are different regimes for the two areas.

After the criticisms that gas privatisation had failed to liberalise the gas market, the government decided that, to reduce incumbent power and to attract new entry to electricity generation and supply, the generation and transmission functions previously in the CEGB should be separated. The National Grid Company (NGC) was established as a transmission company which allows access on equal terms to all parties, which despatches plant under the pooling regime (3.4 below) and operates two pumped storage power stations. All shares in NGC were initially held by the Regional Electricity Companies (RECs) but it is due to be floated separately towards the end of 1995.
It was decided also that, to promote competition in generation, the CEGB's generation activities should be divided between two companies - National Power and PowerGen. During the debate about the appropriate form of electricity privatisation, proposals had been made for a more radical scheme in which the CEGB would be divided into six or more generators. $ ^{[11]} $ But the CEGB strenuously opposed both the separation of transmission from generation and any division of generation. It was not so successful as British Gas had been in its attempt to remain whole but it did succeed in persuading the government that a division into only two generators should be made. Only 60 per cent of the shares in the two generators were sold at the time of privatisation: the government retained the other 40 per cent until they were sold in March 1995.

Distribution and supply of electricity to consumers in England and Wales were placed in the hands of twelve RECs, each based on an existing Area Board. RECs must make their distribution networks available to third parties on the same terms they apply to their own supply businesses. RECs are also allowed to generate electricity, but (to prevent the emergence of vertical integration) only up to a limit of 15 per cent of their supplies. $ ^{12} $

To permit competition in supply to develop, the privatisation scheme provided for each REC's monopoly power to be gradually reduced. From 'vesting day' (1 April 1990) large consumers with a maximum demand in excess of 1 MW (about 5000 in total) were allowed to 'shop around' for electricity: they could take supplies from their local REC, or via 'second tier' supply from another REC, from one of the generators (though there were some limits on direct sales by National Power and PowerGen for a short period) or from one of the Scottish companies. The threshold for the monopoly market was reduced to 100 kW in April 1994 bringing about 50,000 more consumers into the competitive market. From April 1998 onwards there will no longer be a captive 'franchise' market of smaller consumers. All consumers (including residential) will be able to choose supplier. A novel feature of electricity supply in England and Wales is therefore that, on present plans, by 1998 all electricity consumers will have the power of exit.
### 1.5 The problem of nuclear power

Nuclear power caused the government considerable difficulties as it proceeded to a flotation of shares in the new electricity companies. $ ^{13} $ The 1988 White Papers envisaged privatisation of nuclear power. Existing nuclear stations in England and Wales were to form part of National Power, the larger of the two generating companies: indeed, one of the principal reasons why the government opted for only two generators was that it wanted to establish a very large company within which the nuclear stations would not appear too prominent. But that part of the scheme was thwarted in 1989. The City was alarmed not only at the estimates of nuclear generating costs but also at the uncertainty associated with those costs. Estimates of back-end costs, in particular, increased sharply in 1988 and 1989 when the privatisation scheme was under discussion and more information was revealed about nuclear costs than had previously been available. $ ^{14} $

As the success of privatisation appeared threatened, first Magnox stations and then the AGRs were withdrawn from the scheme: by November 1989 the government had conceded that it would have to retain nuclear stations in state ownership. One nationalised company (Nuclear Electric) took over nuclear stations in England and Wales - Magnox, AGR and one PWR (Sizewell B) under construction. Another company (Scottish Nuclear) took over the two Scottish AGRs and a Magnox station which was being decommissioned. There had been a plan to build three more PWRs to complete a 'family' of four but this was dropped, at least temporarily, in November 1989 when existing nuclear stations were withdrawn from privatisation.

At the same time, a system was established under which the RECs are contractually obliged to take the bulk of the output of the nuclear stations in England and Wales as baseload under a Non-Fossil Fuel Obligation (NFFO). Essentially, the system is that the RECs are compensated from the proceeds of a fossil fuel levy (amounting to around 10 per cent on most electricity bills excluding auto-generators and CHP plant) for the excess cost of using nuclear electricity as compared with fossil-generated electricity. $ ^{15} $ This form of protection was originally due to cease in 1998 but, under new proposals to privatise nuclear power (see 5.2 below), the government said in May 1995 that protection would end in 1996.
### 1.6 Privatisation in Scotland

The privatisation scheme for Scotland involved less disturbance of pre-existing arrangements than in England and Wales. Two vertically-integrated private companies were established, one (Scottish Power) based on the SSEB and the other (Hydro Electric) based on the NSHEB. The nuclear stations built by the SSEB were, as explained above, transferred to Scottish Nuclear: under a Nuclear Energy Agreement which lasts until 2005, all their output must be taken by Scottish Power and Hydro Electric. Until 1994, Scottish Nuclear received a premium price; but from 1995 onwards the price is gradually to be brought into equality with the baseload price in the England and Wales pool. According to the 1995 nuclear privatisation proposals (1.5 above), the premium price scheme for nuclear electricity in Scotland will end in 1996 (when the fossil fuel levy ends in England and Wales).

### 1.7 Regulation

Regulation of the industry is, as in other privatised industries, in the hands of a specialist regulatory office - in this case, the Office of Electricity Regulation. OFFER licenses companies in the industry; it can modify licences with the consent of the holder or refer matters in dispute to the Monopolies and Mergers Commission (MMC). In some cases it has joint powers with the Secretary of State for Trade and Industry. Price regulation formulae of the RPI-X variety, similar to those used in other British privatised utilities, are applied separately to transmission, distribution and supply charges and reviewed at intervals of five years or less. The price cap formula is not applied to generation since the government assumed there would be sufficient competition to protect consumers. That assumption has turned out to be incorrect as explained in 3 below.

### 2. Privatisation, nationalisation and government failure

### 2.1 Differences from nationalisation

The privatised electricity market is very different from what went before. $ ^{16} $ In addition to the structural changes at the time of privatisation, the three most significant differences are

0 entry is now permitted to both the generation and supply businesses whereas previously it was prohibited by the state;

0 the electricity companies now have private shareholders, instead of being owned by government;
0 regulation is by an independent body instead of being conducted behind closed doors, with unclear rules, by politicians, civil servants and industry managers.

In principle, these changes should have been beneficial. Actual and threatened entry should have brought increased rivalry in generation and supply, leading to increased efficiency pressures and lower costs which, in a competitive market, would have been passed on to consumers in the form of reduced prices and better standards of service. The industry's entry into the market for corporate control should also have enhanced efficiency pressures and reduced the incentives which existed under nationalisation to concentrate resources on political lobbying: the industry's decisions about which fuels to use, which investments to make, whether to purchase British or overseas equipment and services and what prices to charge should no longer have been subject to government influence. Regulation should have been confined to natural monopoly networks and based on clearly defined rules.

In practice, however, many of these potential gains have yet to be achieved.

### 2.2 Government failure and electricity privatisation

Of course, it was to be expected that competition would take time to find roots in the British electricity market. After all, the industry had been nationalised for over forty years and, before that, was supervised by government. Competitive habits take time to form and market participants have to learn to substitute contractual relationships for the old co-operative relationships within firms.

However, the reason why many of the potential beneficial results of privatisation and market liberalisation are so far unrealised is not just that insufficient time has elapsed. The underlying problem is government failure to establish at the time of privatisation conditions in which a competitive process could flourish in product markets. $ ^{17} $ Government also seemed unwilling to expose companies in the industry to the threat of takeover, using the device of 'golden shares' as in other privatisations. $ ^{18} $

Particular difficulties have been caused by the decision to establish a duopoly in generation. Since generation has no natural monopoly elements and a rivalrous market clearly could have been created, that decision was seen by some economists as a serious error. $ ^{19} $ It has had consequences the government evidently did not intend. Despite substantial entry by new generators, the market power of National Power and PowerGen has not as yet been significantly disturbed: as explained below, the
pooling system and the contractual relationships which have developed (partly because of the duopoly) have allowed the two major generators to retain their influence over wholesale prices. Competition in supply to larger consumers has developed, but genuine competition in generation is still lacking: it is symptomatic of the absence of rivalry that the regulator has had to supervise generation much more closely than the government expected (5.2 below).

In the rest of this paper, the characteristics of the privatised market are analysed, with the emphasis on those which have inhibited competition, and regulation is discussed. Since one of the most fundamental issues is the duopoly and its consequences, that is the starting point.

### 3. Competition in generation

### 3.1 The generation duopoly

Whatever the privatisation scheme, incumbent generators would have had some advantages over entrants. In addition to the usual 'advantage' of having plant with sunk costs (but see 3.3 below), they possessed sites linked into the transmission and distribution systems; more generally, as descendants of the nationalised industry they could take advantage of that industry's near-monopoly of information about all matters relating to electricity generation in Britain. $ ^{20} $

But the duopoly structure of generation imposed by the privatisation scheme gave considerable additional power to the two major generators. Electricity is a product for which the short period price elasticity of demand is low yet, since the product is homogeneous, the price elasticity of demand for the product of any generator is very high. Thus conditions exist in which a small number of producers can take advantage of the inelasticity of the market demand curve by suppressing competition among themselves.

Establishing a duopoly, as the British government did, made it relatively easy for incumbent generators (and later Nuclear Electric - see 3.7 below) to avoid forms of competition which would have disturbed their market power. That is not to suggest they had explicit agreements. Tacit collusion - which is relatively straightforward in a duopoly, particularly when the two companies have been formed from one parent and probably have good knowledge of each other's costs - is a
much more likely outcome of this kind of market.

### 3.2 Entry and constraints on competition

Nevertheless, given that entry to the market was freed, the initial structure might appear of only transient importance: the power of any duopoly would seem unlikely to persist because of a Schumpeterian gale of creative destruction $ ^{21} $ in the course of which entrants would compete away the profits of incumbents to the benefit of consumers. Possibly electricity privatisation is at too early a stage for one to judge when such a gale will gather force. But there are a number of severe constraints on competition, which may persist for many years, and which have so far shielded the major generators from the rivalry of entrants. These constraints are analysed below: all are either unintended consequences of the duopoly or of past government actions.

### 3.3 Fuel use, entry and the 'dash for gas'

One of the most significant changes consequent on privatisation was relaxation of political constraints on generator fuel choice. These constraints had been in operation for over thirty years and were one of the prime determinants of the initial fuel mix of the privatised industry.

Under nationalisation governments ensured that the industry burned British coal and constructed British-designed nuclear power stations (1 above). The CEGB's fuel mix at the time of privatisation therefore consisted largely of coal, with a substantial additional element of nuclear power. To maintain support for British coal and nuclear power, successive governments operated a de facto ban on the use of natural gas in power stations, starting in the mid-1960s when gas was found in the southern North Sea: $ ^{22} $ it was subsequently reinforced by a similar move by the European Community. Because of these prohibitions, there was considerable pent-up demand for gas as a generation fuel by the time of electricity privatisation in Britain.

On privatisation, with government constraints on fuel use relaxed, the two major generators in England and Wales immediately began to diversity away from a fuel mix which they perceived to be costly relative to the alternatives' and excessively polluting. About three-quarters of their plant capacity was coal-fired or dual-fired (coal and oil), with the rest mainly oil, as Table 1 shows. Their fuel mix was an incumbent disadvantage which offset some of their advantages. They no longer had any nuclear stations, though the output of those stations had to be taken by the RECs and had a share of about 17 per cent of pooled output in 1990 (Table 2).

For a time the generators' diversification moves were severely hampered by government