COLUMN-UK utilities unmoved by threat of competition review: Kemp

Fri Mar 28, 2014 8:51am EDT

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(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, March 28 (Reuters) - Britain's major gas and electricity suppliers shrugged off the threat of a market investigation by competition regulators as investors concluded it is unlikely to recommend changes that could significantly affect their profitability.

Of the country's Big Six gas and electricity suppliers, only Centrica and Scottish and Southern Energy are directly quoted on the stock market.

Centrica's share price closed up marginally, though its shares have been hit hard since speculation about future regulatory reforms began in September 2013.

SSE's shares fell 2 percent but the company is still trading close to its highest levels for the last decade.

The other four big retailers are part of large diversified groups so the impact of Thursday's report from the Office of Gas and Electricity Markets (Ofgem) on their share prices cannot be observed directly.

But if the proposal to refer gas and electricity suppliers for a full-scale competition review was meant to signal a revolution in the country's energy business it seems to have left investors unmoved.

The report's scathing tone may have taken some in the industry by surprise, however the decision to refer the gas and electricity supply business for a competition review has been widely expected.

Some within the industry have actually been calling for a competition reference in the hope it would take the issue out of the political arena and enable it to be settled once and for all by a thorough and technocratic process.

The bottom line is that it is not clear whether the competition review will or could recommend changes that would significantly alter the returns available to investors in the country's gas and electricity businesses.

For all its damning language, Ofgem's report struggles to explain exactly what the problem is that a competition investigation is meant to solve.

FLAWED MARKET

There are plenty of flaws in Britain's energy markets.

Customers have been deliberately confused by a bewildering array of complicated tariffs.

Former regional monopolies remain dominant in their old areas and continue to charge higher prices to their legacy customers.

Few customers switch supplier so the threat poses little real constraint on the prices gas and electricity suppliers charge. The number of customers who say they do not trust their energy supplier hit a record 43 percent in 2013.

Retail prices tend to rise quickly when wholesale prices go up, but fall slowly when wholesale costs go down. Price increases tend to be synchronised and Ofgem says there may be "tacit coordination" among the major firms although it has no hard evidence.

Entry barriers remain formidable. Centrica, the country's former gas monopoly, still has a gas market share of more than 40 percent. The former regional electricity monopolies have an average market share of 37 percent in their home areas. Small independent suppliers have grown rapidly in recent years but their total share of the market is still just 5 percent.

In electricity, vertical integration between generation and retail distribution has left small independent suppliers at a disadvantage and led to suspicions that the Big Six are hiding their true level of profitability by shifting profits from distribution into the less transparent generation business by manipulating transfer pricing.

Ofgem lays out all these concerns in convincing detail in its report.

But the real political problem is that prices have risen much faster than inflation over the past decade, squeezing household budgets at a time when incomes have stagnated owing to the financial crisis and recession.

RISING PRICES

The causes of price increases are not hard to find.

Wholesale gas prices have risen sharply. The country's ageing and carbon-emitting coal-fired power stations must be replaced with cleaner gas-fired power plants and wind farms to comply with EU directives and the government's own climate change targets, which is expensive.

Most of the country's nuclear generating capacity was designed and built in the 1960s and 1970s and is rapidly nearing the end of its service life and must be renewed or replaced. The bulk of the transmission network is even older, dating from the 1950s and 1960s, and needs a major overhaul.

To reduce carbon emissions and encourage generation from nuclear, wind and solar in future, governments from all political parties have provided a range of generous subsidy programmes, all of which are being charged to utility customers through their bills.

On the demand side, Britain's housing stock is mostly old, poorly built and thermally inefficient. Government programmes to improve weatherisation and energy efficiency are being paid for by levying additional charges on utility bills rather than through general taxation.

For all these reasons, there is no question energy bills would have risen significantly since the turn of the century.

In real terms, household energy bills are still below the level in the 1970s and 1980s. In retrospect it is the low utility bills in the 1990s that look like the anomaly rather than the high bills of the 2000s.

But the combination of rapidly increasing bills, economic stagnation and falling real wages since 2008 has proved a poisonous cocktail.

The real question for politicians, regulators and customers is whether the Big Six have made the rise in bills worse by exploiting their dominant position in gas and the generation and distribution of electricity.

On this point, Ofgem's report is least convincing. Ofgem points to lots of flaws in the way that the market is working but is unable to show any evidence that they have allowed the Big Six to inflate prices and profits.

THIRD REVIEW

All the matters which Ofgem is now proposing to refer to the new Competition and Markets Authority (CMA) have already been considered by the regulator before in its own 2008 Energy Supply Probe and 2010 Retail Market Review.

The sceptical observer might wonder whether yet another review will uncover any more evidence that has not already been unearthed by the two previous inquiries.

Many of the problems, such as the bewildering array of tariffs, have already been addressed by reforms arising out of the earlier probes. But the fundamental question of excess profits remains unanswered and undefined.

Overall profits earned by the Big Six from their retail and generation businesses have risen moderately since 2009.

But while profits earned from supplying residential customers have risen more than four-fold, profits from the non-residential supply business and generation have shrunk.

There is an enormous amount of variability among the Big Six in where they earn their profits (gas versus electricity, retail versus generation).

It is therefore far from clear that anyone is earning a significant amount of excess profit.

One persistent concern is that vertical integration has allowed retailers to hide excess profits in their unregulated generation businesses, as well as making it hard for independent retailers to acquire the wholesale gas and electricity supplies needed to enter the market.

Some commentators have suggested the Big Six should be broken up and that no firm should be allowed to operate in both generation and retail. But it is not clear if this would lower prices for consumers.

Britain currently needs more generation capacity. For all commentators claim generators are making excess profits, the government is struggling to encourage new investment in generation capacity at the moment.

In future, the government will probably have to give generators more incentives, not fewer, to build and run new capacity in a bid to ensure the lights remain on.

Small independent suppliers claim they are much cheaper than the Big Six. But most are able to cherry pick their customers and mostly serve affluent and informed households.

Small suppliers do not have the same environmental and social obligations as the Big Six (including supplying subsidised energy to vulnerable low-income, disabled and elderly customers, dealing with customers with poor credit histories, and insulating old homes).

So it is not clear small independent suppliers could deliver gas and electricity to the average household much more cheaply than the Big Six do at present. (Editing by Keiron Henderson)

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