Regulation

Facts, Analysis and Comment.

Energy Regulation

The History of Energy Regulation through to 2010

Government intervention in energy markets has gone full circle over the last forty years. Back in the 1970s, when it owned the gas and electricity industries, government not only had a hand in all significant decisions, but it also tasked those industries with a number of incompatible objectives, and especially social objectives. It then privatised the industries in the 1980s and established independent regulators (in due course consolidated into Ofgem) who focussed on introducing effective competition and (if necessary) controlling prices. But government intervention began to grow back, beginning around 2003, and is now substantial.

This chart shows very clearly that - whatever its other virtues, for instance its willingness to tackle climate change - Government interference in the energy market seems inevitably to lead to higher prices. (See also Note 2 below.)

The structure of the privatised industry has several tiers.

Generation and Storage

1. First of all, one set of wholesale companies (including electricity generators and gas storage companies) compete to supply gas to, and generate electricity for, the suppliers - see '4' below.

Transport

2. The energy is then transmitted around the country by transmission companies such as National Grid.

   

3. It is then distributed to consumers by 14 distribution network companies such as Western Power Distribution which owns and operates the power grid in South Wales, the Midlands and the South West of England.  Each one is a regional monopoly whose prices are set by Ofgem.

Supply

4. Customers deal only with suppliers who buy energy on customers' behalf, reimburse the transmission and distribution companies for their services, and issue bills etc.

The theory underlying this structure looks sensible. The original big idea was to get the benefit of generation etc. competition through to customers. In other words, your and my supplier would seek out the cheapest gas and electricity on our behalf, and if they failed then we would switch to another supplier. The wholesale companies (1) would compete with each other, as would the customer-facing suppliers (4). And Ofgem would control the prices of the transition and distribution natural monopolies (2 & 3). In practice, however:

There were nevertheless around 20 years in which government did its best to leave energy policy to Ofgem and the market. This was initially pretty successful. A good deal of competition, if not fully effective competition, developed in electricity generation and in gas/electricity supply to homes and businesses, thus allowing price controls to be removed from these elements of the supply chain. Transmission and distribution remained price controlled, because the pipes and wires created natural monopolies. As a result, operating costs fell by over 50% in real terms following privatisation, and UK gas/electricity prices became lower than prices charged in most other comparable countries. However, a number of factors (including concerns about climate change, concerns about nuclear generation, increasing gas import dependency, and the closure of ageing power stations - all of which led to increasing retail gas/electricity prices) meant that energy policy inevitably became much more political, and control of energy policy slowly drifted away from Ofgem and back to the Government.

The process probably began in 2003 when a significant power outage in London alarmed both the industry and the Government and led to increased spend on distribution networks. But concerns about climate change, and the apparently inexorable rise in the price of fossil fuels, led the Government of the day to demand increased emphasis on de-carbonisation and the generation of energy from renewable sources, thus creating lots of policy conflicts. From 2004, therefore, Ofgem was no longer allowed to concentrate on economic regulation but instead had to take note of environmental and social guidance which required it to seek

(a) carbon reduction,
(b) reliability and security of supply,
(c) competition, and
(d) adequate and affordable heating.

But Ofgem was offered no guidance on how to prioritise these conflicting objectives. Indeed:- 'The Government has not sought to rank the four objectives set out in the White Paper. It is the Government's view that these objectives can be achieved together and the Government has put in place policies designed to achieve this.'

The next significant development was when the Department of Energy, which had been absorbed in the Business Department in 1992, was resurrected as the Department of Energy and Climate Change (DECC) in 2008. Ofgem continued to remain much more independent than its counterparts in most other EU countries. But it became increasingly unpopular with the then Labour Government which was frustrated by Ofgem's refusal to refer the energy market to the Competition Commission.

A New Government

Energy policy had risen to pretty near the top of the political agenda by the time of the 2010 General Election. This was because politicians found it very difficult to establish a satisfactory combination of policies which (a) tackled climate change, and (b) encouraged investment in new generating and distribution capacity without also (c) increasing taxes or energy prices to an unacceptable extent.

Pre-2010 Labour Party politicians had hoped that Ofgem would help them by referring the energy market for a full (and likely two year) investigation by the Competition Commission (CC), but it had not done so. However, after the 2010 General Election, when it looked as though a reference might be made, Conservative junior minister Charles Hendry intervened so as to delay a reference. He clearly interfered in Ofgem's independent decision making when, in February 2011, he told The Times that "suppliers might be too important to future energy security to be exposed to the full rigours of a competition investigation ... We have to be aware that these are the same companies which we are asking to help find much of the £200 billion of investment in the energy market that this country needs ... This is not an issue just about prices". Commentators were not impressed. Andrew Ellison said that the 'cowardy custard' Minister ought to 'show more backbone ... we have gone from a sofa style of government to a hide-behind-the-sofa style of government ... Besides, it is hard to imagine that energy suppliers would refuse to invest in one of the largest economies in the world simply because they are forced to charge a fair price'. Mr Hendry was sacked in Prime Minister David Cameron's first reshuffle in September 2012. But there was still no reference to the CC.

Later in 2010, Ofgem's rather good Project Discovery Report was said to have appalled the new Coalition Government who did not wish the public to be told about the regulator's concerns about insufficient generation capacity. But the Government was forced to conclude that, if it did not act by investing in gas-fired power station, then lights would start going out (including in poor people's homes) well before (climate change driven) water started lapping at voters' doors! However, rightly or wrongly, the Government in general, and DECC and Infrastructure UK in particular, did not trust Ofgem to drive through the necessary energy price rises necessary to ensure the required investment in their sectors. The obvious conclusion, in the Government's view, was to take firm control of energy policy. They accordingly established an internal Electricity Market Reform Project and an Electricity System Programme - both the sorts of jobs that would in earlier times have been carried out by Ofgem. (Contrast Ofgem's earlier responsibility for developing NETA, the New Electricity Trading Arrangements introduced in 2001.)

(There is a note here about concerns that there will be insufficient electricity generation capacity in forthcoming winters.)

The policy of the new coalition government accordingly became driven by four factors:

The Government's 'dash for gas' (and nuclear) is described in more detail here.

A number of announcements, in December 2010, led The Times to headline its report 'Energy all-change means bigger household bills for the next 20 years'. One element of this package was Ofgem's abandonment of the familiar RPI-X price control formula, which exerts strong downward pressure on industry costs. Instead, the regulator was switching to RIIO, in which Revenues are determined by levels of Innovation, by Incentives and by the Outputs they deliver. Costs and efficiency (and hence lower prices) thus became much lower priorities, whilst investment, including in green technologies and a 'smart' grid are encouraged. Speaking some years later, Ofgem Chair David Gray said that the main features of the new approach were:

He also felt that the new approach had been found to work well, noting in particular that the resultant price controls had been upheld on appeal by the CMA - at least in seven and a half of the nine main grounds of appeal.

Notes

1. The gas industry was originally privatised as a vertically integrated 25 year monopoly. There were, after some time, then a series of investigations by the Office of Fair Trading and the Monopolies and Mergers Commission (now the CMA). At least one of these was welcomed by British Gas itself which then decided to separate itself into two companies - upstream transport and storage; and downstream supply to the customer.

2. Secretary of State for Energy, Tony Benn offered to impose gas price increases on customers so as to help the government to meet tough IMF borrowing targets. An incidental benefit of this (in Mr Benn's mind) was that it would help his beloved coal industry.

3. There was a famous episode in the early days of electricity regulation when the regulator, Stephen Littlechild, was forced to re-open a price control after only around a year after setting it. In brief:

 

Martin Stanley