Silviase/jgov_v1.4_full_ann huggingface dataset:
insistence that they sign contracts with British Coal for the first three years of privatisation (up to March 1993) to take substantial amounts of coal - 70 million tonnes a year reducing to 65 million tonnes. The extra costs incurred by the generators in signing these contracts appear to have been passed on via the RECs to consumers in the franchise market. But the generators were still able to lay plans to build new CCGT stations, to be commissioned post-1993, which appeared the cheapest form of baseload generation, which had short construction times (two to three years) compared with coal or nuclear stations and which also offered advantages in meeting EC sulphur emission targets. From 1993 onwards, the coal contracts were reduced - to 40 million tonnes in 1993/94 and 30 million tonnes a year for the next four years - and constraints on fuel choice were much diminished.

At the same time, entrants to the generation industry appeared, all choosing to build CCGT stations. The resulting 'dash for gas' was on a considerable scale. By early 1995, National Power and PowerGen had 6300 MW of CCGT stations either commissioned or under construction. As well as their wish to diversify away from coal, the two generators may have been making a pre-emptive strike at potential entrants by building, and announcing plans to build, CCGT stations. Further comments on the generators' possible motivations are in 6.1 below. Whatever the reasons, by early 1995 entrants had commissioned or under construction a little more CCGT plant than National Power and PowerGen - about 6900 MW (over 10 per cent of pooled generation capacity in England and Wales). $ ^{23} $ One consequence of the 'dash for gas' was to accelerate the decline of the British coal industry (see 6 below).

As a result of new entry (and also an increase in Nuclear Electric's market share), there has been a substantial decline in the shares of National Power and PowerGen of pooled output. In 1990-91, as Table 2 shows, National Power's market share was over 45 per cent and PowerGen's share was 28 per cent: but in the year ending September 1994 those shares were down to 34 per cent and 25 per cent respectively. Nuclear Electric, which has been successful in increasing the output of its AGRs, increased its share from 17 to 23 per cent over the same period. New entrants accounted for about 7 $ \frac{1}{2} $ per cent of pooled output in the twelve months ending September 1994 and that share will increase to about 10 per cent as capacity under construction is commissioned.

### 3.4 The pool and its effects

Given this volume of entry in a relatively short period, it might seem that the market power of the major generators would inevitably be curbed. But, despite the reduction in their market share, the impact on their ability to set prices has been minimal: as explained below, the electricity pooling system in England and Wales, established by the privatisation scheme, has concentrated their influence on a crucial segment of the market to such an extent that they continue to be price-makers.
The electricity pool is a central despatch and settlement system in which the National Grid Company (NGC), the privatised transmission company, has a central role in matching supply and demand. $ ^{24} $ Under nationalisation, the CEGB operated a ‘merit order’ in which it despatched plant in ascending order of operating cost. Under the new regime, pool membership is a requirement of generation and supply licences so all substantial generators are compelled to use the pool. Electricity supplied to Britain via a 2 GW link with France is also sold into the pool. Generators submit price bids for each generating unit for each half hour of the following day. NGC then orders the bids and despatches plant in merit order to meet its estimate of demand. A difference from the nationalised regime is that the merit order is based on price bids rather than estimated operating costs.

Each generator receives a price which is the sum of two elements. The first is the System Marginal Price (SMP) which is the price bid by the marginal generating unit in the relevant half hour. The second is a capacity payment for all capacity declared available (whether or not it runs) which is the product of the 'loss of load probability' (LOLP) and the 'value of lost load' (VOLL).

VOLL is intended to place a value on the cost to consumers of a power shortage. It was set initially at $ £2 $ per kWh, indexed to the rate of inflation: in an apparent hangover from the days of nationalisation a central judgement is made about how consumers value lost load rather than those consumers being allowed to decide for themselves. The effect of the capacity payment term in the pool price formula is that as demand moves closer to declared capacity, so the LOLP increases and payments to generators increase. Thus incipient shortages translate into a price signal to make more existing capacity available and to invest to increase capacity, albeit the signal is based on an apparently arbitrary estimate of VOLL.

Purchases of electricity are not at PIP but at the pool output price (POP) which is higher at certain times of day to the extent that it includes 'uplift' payments - for example, to cover the cost of transmission constraints, maintenance of reserves and other system costs.

This pooling system has combined with other characteristics of the privatised electricity market to accentuate the market power of National Power and PowerGen. If entry to the generation industry consisted of a diversified mix of plants in terms of load factor - some operating on baseload, some mid-merit plant and some peaking plant - SMP would be set in rivalrous conditions. However, in practice National Power and PowerGen have set SMP almost all the time because of the lack of competition outside the baseload power market.

### 3.5 Entrant/REC relationships

The reasons why there is minimal competition outside the baseload market are traceable back to establishment of the duopoly, to avoiding action taken by the RECs and to the characteristics of contracting under the privatised regime.
As already explained, all entry to generation has so far been by companies with CCGT plants. Most entrants are associated with one or more RECs which either have an equity stake in the company or a long-term (usually 15-year) contract with it for the supply of power. RECs have regional monopoly power - they are incumbents with a monopoly over smaller consumers until 1998 and, as successors to the old Area Boards, a near-information monopoly about local conditions - and so possess considerable freedom of manoeuvre in contracting.

RECs have used this freedom to form close equity or contractual relationships with entrants to generation $ ^{25} $ because they have wished to diversify sources of electricity supplied to them, avoiding dependence on a duopoly in generation. RECs are limited in the amount they can generate themselves to 15 per cent of supplies (1 above) but they are not restricted in their ability to contract with entrants to generation provided they meet an obligation to purchase economically. Thus the presence of a generation duopoly has more significance than the direct constraints it places on competition in generation. It has led also to the REC/entrant relationships just described: had the CEGB been split into more generators, the RECs would have had less incentive to diversify in this way. $ ^{26} $

These contractual relationships have in turn influenced the development of competition as between baseload and non-baseload. The long-term contracts which the entrants have with RECs are mirrored by the long-term contracts entrants have signed to take gas from fields in the North Sea. These contracts are 'take-or-pay', as most North Sea gas contracts have been since 1968 when British offshore gas first began to flow: take-or-pay contracts with high minimum bills are a characteristic development in a monopolised and monopsonised gas market such as existed at that time as a matter of government policy.

Because they have take-or-pay, minimum bill contracts, entrant generators find a large element of their gas purchase costs is fixed. Thus the marginal cost of gas to them is zero and they have a powerful incentive to maximise the volume of their gas sales by bidding into the pool at whatever price will secure baseload operation. Thus despite the large volume of entry, all the entrants' plant runs on baseload. None competes with mid-merit and peaking plant. Nuclear stations also run on baseload. All non-baseload plant (left over from the days of nationalisation) apart from pumped storage is still owned by National Power and PowerGen. Consequently, SMP is set about 85 per cent of the time by those two companies (in most of the other 15 per cent, NGC's pumped storage stations set SMP - see 5.1 below). Two recently announced CCGT projects (with a capacity of about 1000 MW in total) seem to be on a different basis: it appears that in neither case is there a long-term power purchase contract with a REC but it is not clear whether they mark the beginning of a new
### 3.6 Unintended consequences and the development of competition

Summarising, the British government’s privatisation scheme for electricity generation resulted in a stream of unintended consequences.

First, in order to placate the management of the CEGB and to make nuclear privatisation easier (though in the event that privatisation did not take place in 1990), the government established a duopoly in generation. Second, because of past government action there was a huge pent-up demand for gas which meant that any new entrants would build gas-fired plant, buying their gas in a market where (again because of past government actions) take-or-pay contracts were the norm. Third, the RECs - concerned at the market power of the duopolists - decided to circumvent it and so teamed up with new entrants on long-term contract. Fourth, all the new plant is on baseload and so competes with existing generators only in that part of the market. Thus the incumbents retain market power in that crucial segment of the market where, because of the characteristics of the pooling system, prices are set. The market features mentioned above have controlled competition, channelling it into areas where it would least affect incumbents and have least impact on wholesale prices. Some of the effects on prices to consumers are discussed in 4 below.

The (unintended) consequences for competition in generation are serious. A recent calculation by the Office of Electricity Regulation $ ^{28} $ shows that in 1993-94, National Power and PowerGen had 95 per cent of non-baseload output (compared with 55 per cent of baseload output). So entry to the industry has depressed the major generators' share only of baseload output. Of course, as National Power and PowerGen stations are displaced from baseload they compete with mid-merit and peak plant: but virtually all the plant concerned is owned by the two big generators so, as OFFER concluded, 'The two companies are thus competing only with each other for a critical part of the load curve'.

Another feature of generation which the Director General of Electricity Supply (DGES) has pointed out, $ ^{29} $ is that the major generators' shares of capacity have declined less than their shares of output. On vesting day, their combined share of output was the same as their share of capacity - 78 per cent. But, though their share of output has declined to 59 per cent their share of capacity has fallen much less - to 69 per cent. The presence of this substantial amount of spare capacity waiting in the wings - which can be brought into the market if the two generators choose and will then affect capacity payments - is likely to be a deterrent to entry.
### 3.7 The contracts market

Although most generated electricity is pooled, there are considerable risks to market participants in relying on a spot market such as the pool, particularly in view of the distortions discussed above. Variations may occur not only for the reasons one would expect in any electricity market - according to time of day and season of year and because of unexpected weather or other unpredicted events. In the pool, there is the possibility of strategic gaming by the duopolists. $ ^{30} $

Experience has now revealed how large variations in the pool can be and how they tend to be magnified by the LOLP/VOLL mechanism (see 3.4 above). In January 1995, for instance, there were some particularly large fluctuations in pool prices, caused apparently by the temporary closure of two nuclear power stations which affected prices primarily by increasing LOLP. On one day in late January, PIP reached a maximum of over 63 pence per kWh between 17.30 and 18.00 hours with a corresponding POP of over 72 pence, as compared with minima in the early hours of the same day of only 0.9 pence. On another day in April 1995, there was a short period during which the input price rose above 83 pence per kWh (though there were evidently software problems at the time). $ ^{31} $

To protect against pool price fluctuations, a contract market has developed in England and Wales through which most electricity is traded. ‘Contracts for differences’ (CFDs) - in which the differences are from a strike price - between generators and electricity suppliers settle in advance the price at which most electricity is bought and sold, thereby protecting against the uncertainty of pool prices.

The presence of CFDs tends to make generators less concerned about pool prices than they would otherwise be, but they are not always fully contracted and so may be affected at the margin by pool price fluctuations. RECs and large consumers also protect themselves by CFDs but again some may be affected at the margin and some large consumers (such as ICI and other chemical companies) $ ^{32} $ purchase at pool prices. It is also, of course, true that over a period of years there must be a relationship between pool and contract prices since consumers have the option of buying at one or the other price.

Lack of competition in the contracts market (as well as in the pool) has concerned the industry regulator. There are three big players in the contracts market - National Power, PowerGen and Nuclear Electric - all of which have an incentive to keep up prices rather than compete
vigorously. Tacit collusion in a triopoly is therefore a possibility. OFFER's evidence to the government's 1994-95 nuclear review is forthright about the ineffectiveness of Nuclear Electric as a competitor to the two big privatised generators. $ ^{33} $ It points out that Nuclear Electric has contracted a significantly lower proportion of its output than the other two generators: according to OFFER, its 'limited contribution' to the contracts market may have been a 'significant factor in restricting the availability of contracts and maintaining higher prices than would otherwise obtain'.

### 3.8 Efficiency gains: reducing inputs and input prices

Despite the weakness of competition in generation, one effect of privatisation has been to stimulate remarkable reductions in costs by National Power and PowerGen. $ ^{34} $ Now they are in the market for corporate control and they find political constraints on fuel choice much reduced, the two generators have moved to cheaper and much less labour-intensive gas-fired generation. They have also negotiated lower prices for the coal they are still burning now they are no longer forced by political pressures to contract for such large quantities of British-mined coal.

The most striking expression of these cost reductions is in the manning economies which have been achieved (revealing the degree of disguised unemployment which existed during the years of nationalisation). National Power and PowerGen reduced their workforces by over two-thirds in the first five years of privatisation (Table 3) and are continuing with reductions though at a slower rate. Labour force reductions in the RECs were smaller - about 13 per cent on average between 1990 and 1994.

The prices of generation fuels have also fallen compared with what they were when they were heavily influenced by government actions to protect British coal and nuclear power. In 1994, the major generators paid about 23 per cent less for their coal than they did, on average, in 1988. The price of natural gas, which has only been used on any scale in power generation since early 1993, fell 13 per cent between then and fourth-quarter 1994.

Predictably, given that serious rivalry has yet to develop in generation, a large part of these efficiency gains seems not to have been passed on to consumers. Consumer price trends are analysed in 4 below.
### 4. Consumer price trends

Until recently the results of electricity privatisation in terms of prices were disappointing, even in the sectors of the market where consumers had choice and despite the considerable cost reductions mentioned in 3.8 above. A study carried out in 1992 suggested that prices in the early privatisation period were considerably higher than might have been expected on the basis of pre-privatisation trends. $ ^{35} $ Since 1993, however, prices to most consumers have tended to stabilise or fall.

To place movements in electricity prices in the context of changes in fuel prices in general, Figure 1 illustrates quarterly trends in coal, fuel oil, gas and electricity prices to industry (all expressed in thermal equivalent terms) since first quarter 1988. That period is taken as the starting point because the White Papers on electricity privatisation were published in February and March 1988: from then onwards, electricity prices began to adjust to the prospect of privatisation.

In essence, the Figure shows that average coal prices to industry have fallen somewhat, that gas prices have fluctuated around an approximately constant trend and that fuel oil prices have tended to increase (abstracting from the sharp rise at the time of the Iraqi invasion of Kuwait in 1990). Despite the declining costs of labour and fuel inputs, electricity prices have risen significantly. Comparing fourth quarter 1988 with fourth quarter 1994 (to minimise seasonal effects), the increase is about 19 per cent, equivalent to an annual average compound rate of nearly 3 per cent.

Some specific factors in the electricity market help explain these increases relative to gas and coal prices. One is the considerable electricity price increases just before privatisation which were generally interpreted as government-inspired efforts to 'fatten up' the industry. Another is the loss of a scheme under which about 4 million tonnes of coal a year was provided to the CEGB by British Coal at around world prices: the benefits of the electricity deemed to be produced from this coal were passed on to about 400 large consumers under the so-called QUICS (Qualifying Industrial Consumers' Scheme). Another factor is the gradual introduction of competition because of which only consumers of 1MW or over had a choice of supplier between vesting day in April 1990 and March 1994. As Figure 1 shows, industrial electricity prices in 1994 (when the competitive market had expanded) were rather lower than in 1993.

The companies which have suffered most from electricity price increases are very large consumers which lost their subsidies; according to DTI statistics, $ ^{36} $ (on which Figure 2 is based) 'extra large' consumers were paying 32 per cent more for their electricity in fourth quarter 1994 than in fourth quarter 1989 (1989 is as far back as the statistics go). Companies too small (less than 1MW demand) to have a choice of supplier before April 1994 also fared badly before they entered the
competitive market: in first quarter 1994 they were, on average, paying 25 per cent more for their electricity than in first quarter 1989. By the fourth quarter of 1994, however, the effects of competition were apparent: the average price they were paying was only about 4 per cent higher than in fourth quarter 1989.

Moderately large and medium size consumers - which have been in the competitive market from the beginning and had no subsidies to lose - have, as one would expect, fared better. They had fairly small price increases of about $ 7\frac{1}{2} $ per cent each from third quarter 1989 to third quarter 1994. Prices paid by both groups have been tending to decline recently: in fourth quarter 1994 the prices they paid were about the same as in fourth quarter 1989.

Outside the competitive market, residential consumers - who are the captives of their local RECs until 1998 - have faced big increases in electricity prices since privatisation. Increases in domestic electricity prices have outstripped increases in other domestic fuel prices since the late 1980s. Domestic electricity prices in fourth quarter 1994 were about 48 per cent higher than in the first quarter of 1988 whereas the price of gas (electricity's main competitor in homes) was only 29 per cent higher. Most of the increase in domestic electricity prices took place between 1988 and 1992 since when, eliminating the effect of the imposition of VAT in 1994, prices have fallen slightly.

In general, benefits to consumers (in terms of prices) seem small when set against the efficiency gains since privatisation. The trend does, however, appear to be changing and it may well be that prices to most consumers will fall over the next few years because of increasing supply competition and tighter regulation of distribution charges. $ ^{37} $

### 5. Regulation

### 5.1 The difficulties of regulation in electricity

From the earlier part of this paper it will be obvious how large a burden falls on the Office of Electricity Regulation. In a paper written when the 1988 White Papers on electricity privatisation were published I suggested that the scheme would make the regulator's task '...extremely difficult if not downright impossible' and that 'The root of the regulatory problem...will be the failure to establish an initial structure of generation which is clearly likely to stimulate competition'. With a competitive generation sector, regulation would have been able to '...concentrate on making sure that the way in which the transmission and distribution sectors operated allowed gains to be passed on to consumers in terms of lower prices without loss of service'. $ ^{38} $