History Essay

Question

What were the main approaches to, and problems and effects of, attempting 13 to liberalize the electricity market in (a) England & Wales and (b) then United States?

Answer

Approaches to, problems, and effects of, attempting to liberalize the electricity market in England & Wales and the United States

 

In attempts to liberalize the electricity market, England and Wales adopted an approach involving vertical separation. In this approach, the stakeholders began by identifying four distinct activities within this market; namely electricity generation, transmission in high-tension lines, low-voltage distribution to local users, and supply. Supply entailed contracting for as well as billing final customers. In the context of the British electricity market, two-thirds of the costs incurred go towards generation (Newbery, 2002). Distribution takes up twenty percent while transmission takes up ten percent (Newbery, 2002). The lowest cost, in this case five percent, goes to activities relating to supply (Newbery, 2002).

The so-called “wires” businesses, which constitute transmission and distribution, naturally operate as monopolies and a great deal of regulation is required (Griffin & Puller, 2005). However, in generation and supply, there is potential for competition. For the market to become competitive or liberalized, a market must exist. In this market, generators are required to sell to traders and customers. For traders, the element of competition comes in when they purchase a system for transmitting and distributing electricity in a way that makes them operate as common carriers. In this arrangement, the traders are free to enter into the generation market. Moreover, final customers have the freedom to make a choice on the trader they are going to contract for electricity supply.

In England and Wales, the electricity market does not exist in the context of an unbundled industry (Wolak, 1997). In the unbundled industry, each of the four activities would be under the ownership of different entities. A company that owns a segment in one activity would not own any assets in another activity. However, in the contemporary world, this practice is not common. In the case of England and Wales, the objective of maintaining this vertical separation is to sever the link between the processes of generation and transmission (Millward & Hunt, 2005). Failure to sever this link may create the undesirable scenario where generating companies own transmission while transmission companies are in charge of generation.

The only situation where transmission companies take charge of the generation process is where there is a need for fast-response generation, for example storage hydro and pumped storage (Wolak, 1997). An aspect of simplification of regulation also occurs when activities of distribution and generation are separated. This is because a clear boundary for separating potentially competitive parts from natural monopoly is defined.

An in-depth assessment of the electricity market in the United Kingdom shows that almost all combinations of ownership exist. Between 1948 and 1990, the electricity industry operated as a public entity (Wolak & Patrick, 2001). The body responsible for this undertaking was the Central Electricity Generating Board (CEGB). Twelve area boards also existed that functioned as monopolies in regional distribution. The CEGB also traded electricity with France and Scotland through interconnectors. Scotland has traditionally remained autonomous from Britain while Wales and England are regarded as one country. This phenomenon has been replicated in the electricity supply market.

Attempts at liberalizing the electricity market in England and Wales started with the enactment of the Electricity Act 1989 (Wolak & Patrick, 2001). This Act subdivided the CEGB into four companies. These companies covered the national grid in England and Wales together with its 74 power stations (Wolak & Patrick, 2001). These four companies include National Power, PowerGen, Nuclear Electric, and the National Grid Company (NGC). The country’s nuclear stations were placed under Nuclear Electric while the high-tension grid was put under the NGC. These companies were registered as public limited companies. Moreover, twelve distribution companies were also created within the same category. Today, these twelve companies are referred to as RECs (Regional Electricity Companies). Towards the end of 1990, the RECs were made available for sale to the public. Moreover, sixty percent of PowerGen and National Power were also sold to the public in England and Wales in 1991 (Wolak, 2001). By 1995, the remaining stake had been sold in the same way (Wolak, 2001).

Initially, the intention was to have the twelve nuclear stations under the management of National Power. National Power had been accorded the responsibility of handling aspects of “fossil” generation (Wolak, 2001). This was done in the hope that such an approach would be financially viable. However, the final stage led to the realization that it was not possible to succeed in selling the nuclear stations at a reasonable price.

For nuclear power stations, the best option was to start by undertaking further restructuring. During this period, five gas-cooled reactors were sold to British Energy before eventually being privatized in 1996. The remaining seven reactors were put under the management of the British Nuclear Fuels plc., a publicly owned company. The privatization process also involved the selling of NGC to Mission Energy in 1995 and the selling of RECs’ shares in NGC following the latter company’s floating on the country’s stock market during the same year.

Following the completion of this privatization process, nearly all Regional Electricity Companies entered into investment partnerships with IPPs (Independent Power Producers). As joint investors, these two entities built new, efficient generating stations. The main advantages of these new generating stations included low capital costs, reliance on cheap fuel, and modest economic scale. This efficiency made them compete favorably with the power generation strategy of PowerGen and National Power.

One of the biggest problems encountered in the privatization of the electricity market in England and Wales was the establishment of an electricity pool and the restructuring the CEGB. The move to introduce aspects of market competition within the electricity industry was political (Helm, 2011)). It enjoyed the support of the British Prime Minister, the Chancellor, and the Secretary of State for Energy. These political leaders were aware of the fact that efforts to privatize British Gas and British Telecom had been very unpopular.

The political leaders, particularly those in charge of the Department of Energy, faced a painstakingly complex process of  creating a method through which healthy competition could be created (Helm, 2011). To facilitate this process, the services of merchant bankers, management consultants, and legal experts was badly needed. These professionals needed to provide advice on aspects of market design and market restructuring. One of the most critical questions that these advisers had to address was on whether a least-cost system would be delivered. There was also uncertainty regarding the control and management of the national grid to ensure security and stability within the newly decentralized infrastructure. In other words, the main question was whether the private companies would continue “lighting up” England and Wales (Helm, 2011).

However, chairman of the CEGB was bitterly opposed to the idea of breaking up the organization. He argued that the CEBG’s responsibility to ensure the availability of adequate capacity could not be removed by the onset of the process of the liberalization process. The head of the CEGB argued that the privatization process should have been undertaken using the single-buyer model. In fact, this proposal was contained in the Directive on Electricity unveiled by the European Union in 1998. Under this arrangement, the CEGB would need to enter into contract with various IPPs and secure adequate capacity. It would then regulate the charges levied with the aim of recovering all its costs. This approach was considered efficient because the CEGB would avoid stranding assets. However, technical consultants in England and Wales argued that this approach did not meet the threshold of a competitive market. At this point, a proposal was made on whether transmission could be separated from generation with the objective of organizing a spot market.

Another problem was to ensure that the transmission system was stable. For this stability to be achieved, there was a need for payments to be made for the provision of a number of essential ancillary services, including the supply of reactive power. Other major challenges included unexpected changes in plant availability, fluctuations in electricity demand, and transmission constraints. Moreover, stakeholders in the electricity market had to deal with the problem of risk during the transition into the liberalized electricity market. The contract market into which they were venturing posed major risks because the companies involved lacked prior experience.

The possibility of the occurrence of major losses forced many generators to look for ways of reducing competition to reap higher profits. Firms operating in highly competitive markets involving homogenous products started looking for ways of merging as a way of creating market power. On the other hand, firms that faced the threat of entry endeavored to create numerous barriers to entry. Nevertheless, the best test of success of the attempts at liberalization of the electricity market in England and Wales is on whether the restructuring efforts enable the industry to adapt favorably to today’s changing market circumstances such as adoption of new technology and fuel-price changes. Electricity generation and transmission companies will be said to have succeeded if the adaptation process does not lead to high costs, high price of electricity, and excessively huge profits.

In the United States, the government has adopted a slightly different approach to the liberalization of the electricity market. This approach is characterized by a mixed system comprising of public ownership on the one hand and private ownership that is heavily regulated on the other. However, the US administration is under substantial pressure to increase the level of competition in the market. However, for this to happen, it would be necessary for amendments to be made on the current institutional framework.

Traditionally, the electricity system in the US has been a modeled around federal and state regulations within a system characterized by a combination of private, municipal, and government ownership (Gilbert & Kahn,1996). Competition between various categories of ownership in the industry has always been a defining characteristic of the US electricity market. Ultimately, the industry settled for an investor-ownership model. However, this model created room for various categories of government ownership whose objective was to achieve niche roles.

All along, the federal administration has been playing a crucial but limited role in the electricity market. The functions of the federal authority are mostly restricted at the level of wholesale operations. However, during the late 1990s, drastic measures were put in place to bring about competition and deregulation in the US electricity market. These efforts made the previous arrangement appear completely monopolistic. Within the new framework, American consumers would henceforth be able to buy electricity from any of the different companies offering it.

As these radical changes were being made, many people reflected on the successful campaign that utility managers had waged during the early twentieth century with the aim of protecting industry from any competition. In this regulated system, it was expected that utility managers would gain immense economic and political power. However, the electricity generating companies had not anticipated the problems that occurred during the 1970s. Traditional generating equipment were crippled down by technological stagnation. Moreover, the operations of these companies were greatly affected by the energy crisis of 1973. The environment movement also emerged and began challenging the way utility managers controlled the entire system. Moreover, the position of power managers as “natural monopolies” was increasingly challenged by politicians, academics, potential competitors, and environmental advocates (Joskow, 2010).

Despite this rapid move towards deregulation, the federal administration in the US continues to play a greater oversight role than the UK government. In the US, this role has been maintained largely through constitutional provisions that grant federal authorities express control over interstate commerce. The government regulates even those wholesale transactions involving parties operating strictly within one state. Additionally, the federal administration in the US continues to maintain rights of ownership over majority of the country’s hydroelectric resources.

The investor-owned model contains three basic features. The first one is the existence of franchise monopolies that are geographically distinct. These monopolies are run through vertically integrated companies. The second feature is price regulation whose objective is to put a limit to the profits obtained by monopolies. The third feature is the unwavering obligation to provide service to customers. State governments are responsible establishing administrative agencies for controlling prices, determining franchise boundaries, and enforcing various service conditions.

A number of problems were encountered in attempts to liberalize the electricity market in the US. One of these problems was the growing perception that statewide regulation policies were was pro-producer (Hirsh, 2002). The argument was that they were designed in such a way that it was difficult to limit excessive prices. Such perception is an indicator that the US administration has not yet succeeded in fully liberalizing the electricity market. In fact, England has achieved more success than the US with regard to the liberalization of this market.

Moreover, administrative issues have been posing a major problem during the liberalization process. These issues involved service standards as well as the process of issuing securities. Furthermore, the private companies contracted to generate and transmit electricity faced challenges arising from fluctuations in demand. Another problem involved difficulties faced by private companies with regard to response to technological change. In this industry, there is always a need for the efficiency of various generating units to be increased. Similarly, the technology-intensive process of increasing the capacity of transmission lines has at times proven to be too complicated for private electricity companies.

Additionally, the federal government has had to intervene in the day-to-day running of nuclear power plants through supervision, oversight, and regulation (Bushnell & Wolfram, 2005). Finally, retail rate structures have also been posing serious problems. Traditionally, the industry relies on the rate-of-return approach (Joskow, 2005). In this model, electricity prices are always set in such a way that total costs are covered. Serious problems arise whenever there is a need for fuel cost adjustments to be made in response to price shocks in the global oil market.

In conclusion, liberalization is a long and complicated process. Attempts have been made to liberalize the electricity market in England and Wales as well as in the United States. However, more success seems to have been achieved in England and Wales compared to the US. In England and Wales, private companies are free to carry out operations independently particularly in the areas of generation and transmission. The only major problem encountered in England and Wales was fierce opposition from the top management at the CEGB. However, in the US, a cloud of regulation by the federal government continues to dominate the country’s electricity market.

 

References

Newbery, D. (2002). Privatization, Restructuring and Regulation of Network Utilities. Heinemann, London.

Griffin, J. & Puller, S. (eds) (2005). Electricity Deregulation: Choices and Challenges. Harvard University Press, Boston.

Hirsh, R. (2002). Power Loss: The Origins of Deregulation and Restructuring in the American Electric Utility System. Columbia University Press, New York.

Helm, D. (2011). Energy, the State and the Market: British Energy Policy since 1979. Oxford University Press, Oxford.

Gilbert, R. & Kahn, E. (1996). International Comparisons of Electricity Regulation. Cambridge University Press, Cambridge.

Millward, R. & Hunt, S. (2005). Private and Public Enterprise in Europe. Free Press, London.

Wolak, F. & Patrick, R. (2001). The impact of market rules and market structure on the price determination process in the England and Wales electricity market. Penguin Books, New York.

Joskow, P. (2005). Transmission policy in the United States. Utilities Policy, Vol. 13, No. 2, pp. 95–115.

Wolak, F. (2001). The Impact of Market Rules and Market Structure on the Price Determination Process in the England and Wales Electricity Market. John Wiley & Sons, Boston.

Wolak, F. (1997). Industry Structure and Regulation in the England and Wales Electricity Market. Princeton University Press, Princeton.

Bushnell, J. & Wolfram, C. (2005). Ownership Change, Incentives and Plant Efficiency: The Divestiture of U.S. Electric Generation Plants. University of California Energy Institute, Berkeley.

Joskow, P. (2010). Lessons Learned From Electricity Market Liberalization. The Energy Journal, Vol. 7, No. 1, pp. 9-42.

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