Privatesector P U B L I C P O L I C Y F O R T H E The World Bank October 1995 Lessons from Power Sector Reform Note No. 61 in England and Wales Robert Bacon The 1990 power reforms in England and Wales A framework for retail competition were designed to permit the introduction of com- and regulation petition at both the retail and the wholesale level. Generation was both vertically separated from The reforms sought to foster retail competition transmission and horizontally separated. The by allowing an increasing number of consumers sector was almost completely privatized--only to shop around for the best service. To start this, the nuclear capacity was left in public hands-- final consumers were divided into three classes: and regulation was applied both to promote Small. Consumers with peak demand of less competition and to ensure that the remaining than 1 megawatt (MW) are "franchise cus- monopolies did not exploit their advantage. tomers" who must buy from their local REC. This limit was reduced to 100 kilowatts (kW) The new industry structure emerged with three in 1994 and is scheduled to be abolished in generating companies: National Power (52 per- 1998. RECs have an obligation to serve this cent of capacity at that time) and PowerGen (33 group of consumers at regulated prices. percent), which were privatized, with 60 per- Medium. Consumers with peak demand of 1 cent of their shares sold initially, and Nuclear to 10 MW have a "right to tariff," but they can Electric (15 percent), which was left under pub- also purchase at unregulated prices from the lic ownership. National Power's share of capac- "second-tier" suppliers--firms with a license ity gave it significant market power. The national to sell (mainly the other RECs and the genera- grid company--after separation from the gener- tors). Of the approximately 4,000 customers in ating companies--was transferred to joint own- this class (30 percent of total demand), 40 per- ership by the twelve privatized regional cent were using a second-tier supplier by 1993. distribution companies. (The grid company re- Large. Consumers with demand exceeding tains control of dispatch.) Each of the twelve 10 MW have no right to tariff. Instead, they regional distribution companies (RECs) has two have to negotiate their prices with the sup- separate functions--distribution (through low- plier they choose. voltage wires or, more simply, grid to door) and retail supply (the sale of electricity to final cus- This market structure has a mix of regulated and tomers)--and these functions must be accounted unregulated prices, but even the unregulated for separately. Access to the distribution opera- prices are subject to oversight by the regulator in tion of the RECs is regulated so that any seller his capacity as promoter of competition. The of electricity has the right to "use" the associ- prices for supply to final consumers are controlled ated distribution network when selling to a fi- by the price cap formula--RPI ­ X + Y, where nal customer. Until March 1995, the government RPI is the rate of inflation, X is the estimated retained a "golden share" in each REC, giving it potential productivity gain, and Y is a passthrough the power to block any takeover or merger. factor made up of transmission charges, distribu- tion charges, electricity purchase costs, and a fossil Five years have now elapsed since the reforms fuel levy that subsidizes nuclear power. The fac- began--and this Note discusses some of the tors covered by passthrough account for about lessons starting to emerge. 95 percent of the total costs of supply. Industry and Energy Department Vice Presidency for Finance and Private Sector Development Lessons from Power Sector Reform in England and Wales The distribution charges account for just over 20 The regulator quickly reviewed pool prices and percent of the final price. The initial distribution concluded that the generators could raise prices price caps ranged from RPI + 0 to RPI + 2.5 among above marginal costs in at least two ways. First, the RECs, implying that the prices at vesting were they could declare some plant unavailable and seen as inadequate to cover future costs. Trans- thus affect the LOLP by reducing supply relative mission charges, which account for about 4 per- to demand. Later, after the dispatching schedule cent of final prices, are regulated through a price had been determined, they might even declare cap for which X was initially set at zero. this plant available. Because of the huge differ- ence between the typical SMP and the VOLL, a Wholesale markets--the power pool small increase in the LOLP has a large effect on the pool price. Second, the generators could The most innovative reform was to the pricing manipulate the uplift factor. Because of trans- of power sold by the generators to the RECs or mission constraints, certain power stations were to large final users. The generators sell all power optimal to dispatch even when their price was to a pool. In this power pool (operated by the well above that of the marginal station bid in to national grid company), generators bid to sup- meet the demand. The generators soon learned ply various units in half-hour slots during the to set the bids for these stations well above costs. next twenty-four hours. Dispatch is carried out by choosing plants in merit order of these bids, To prevent the withdrawal of plant that was up to the point at which demand is satisfied. actually available, the regulator appointed an in- dependent assessor. The price spikes disap- The price the generators receive has three com- peared, but big industrial users continued to ponents: the system marginal price (SMP), the complain about the general level of prices. Rather highest price bid by dispatched plants; the ca- than refer the generators to the Monopolies Com- pacity payment, the loss-of-load probability mission, whose decision could have involved re- (LOLP) times the value of lost load (VOLL) less structuring--a decision that would have been the SMP; and the uplift, an adjustment to cover seen as betraying the shareholders--the regula- the costs imposed by transmission constraints, tor in 1994 accepted undertakings by the gen- standby capacity, and the like. The pool attempts erators. The generators specified that they would to mimic an unregulated market, but in fact it bid into the pool so that the pool price would includes a strong degree of regulation (especially average about 2.5 pence per kWh for the next in the setting of the VOLL). To protect themselves two years, and that they would dispose of an- against the potential variability of pool prices, other 6 gigawatts (GW) of capacity within two generators and suppliers have entered into a se- years. The pricing agreement amounted to a 7 ries of short-term "contracts for differences" that percent cut in real prices over the previous year. allow both parties to manage the risks caused by This capping of pool prices cannot be a perma- uncertainty about pool prices. nent solution for a market designed to be com- petitive, however. The regulator probably expects Volatile pool prices that new investment will help to make the mar- ket more competitive over time. The new structure of the generation market im- mediately attracted attention. Pool prices fluc- RECs' profits and shifting structures tuated sharply and, paradoxically, occasionally rose during times of low demand. For example, In the past two years, the RECs have come un- while the yearly average was about 2 pence per der public attack because of their continuing kilowatt-hour (kWh), the price for three half- high profits and the large salary increases hour slots reached 16 pence per kWh on a sunny (boosted by share options) for top executives September afternoon in 1991 and spiked to 33 (table 1). (Profits in generation, though substan- pence per kWh during December. tial, have not been attacked as excessive, and TABLE 1 PRETAX PROFITS AND REVENUE OF THE POWER SYSTEM IN ENGLAND AND WALES, 1992/93 (millions of pounds) supply has been the least profitable part of the Company Pretax profits Revenue electricity business.) The RECs have been only lightly regulated, with the result that growth in National Power 580 4,348 their profits has averaged up to 30 percent a PowerGen 425 3,188 year. Following the first scheduled review of the price cap for distribution in 1994, the RECs Nuclear Electric 661 1,400 had to reduce their charges by 11 to 17 percent GridCo 350 1,396 in 1995­96, and thereafter an RPI ­ 2 price cap RECs was to be used until 1999­2000. Distribution 1,042 3,751 Supply --a 13,921 The rapid growth in the profits of RECs made them attractive targets for takeover. In Decem- a. The companies had small profits or losses. ber 1994, anticipating the expiration of the gov- Source: Mark Armstrong, Simon Cowan, and John Vickers, Regulatory Reform: ernment's golden shares preventing takeovers, Economic Analysis and British Experience (Cambridge, MIT Press, 1994). Trafalgar House bid £1.2 billion for Northern Electric (about four times its selling price at priva- By 1995, the RECs were considering selling off tization), or £10.81 a share. Northern Electric the grid, suggesting that there was no great responded by offering its shareholders a pack- advantage in having left this vertical link at the age worth £5.07 a share to reject the bid, pro- time of privatization (generators are not allowed voking more public criticism. The temperature to own shares in it, though, to prevent anti- rose further when, in early 1995, the govern- competitive links). Because the market value ment sold its remaining 40 percent of shares in of the grid (£5 billion) appears to be consider- the two privatized generators. On the day after ably higher than that used at flotation (the RECs the sale, the regulator announced that the dis- were sold for only £8 billion), the possibility tribution review had not been completed and of returning to final consumers part of any prof- that he would be considering tightening the price its from its sale has been raised. caps. This announcement created a political storm, with the government being accused of An assessment insider dealing. And although new price caps were soon announced that further cut real prices The ultimate aims of the U.K. reforms were to over the next few years, takeover activity has remove the sector from government funding and continued, suggesting that investors still expect to reduce prices for consumers through the in- a good return from what is a low-risk business. creased efficiency of private sector operation Clearly, the government could have held out and the pressure of competition. Broadly speak- for a higher price at the time of privatization. ing, the first objective has been accomplished, but the second objective has yet to be convinc- The RECs have made substantial new investments ingly achieved. Many of the difficulties in achiev- in generation--in a "dash for gas"--despite the ing this second objective are related to the speed overcapacity at the time of privatization. By with which the restructuring and privatization 1993, they had interests in 5.4 GW of plant had to take place. The political pressures at the (mainly combined-cycle gas turbines) under time allowed a relatively short "window of op- construction or in operation. Diversifying sup- portunity," but the desire to privatize the whole ply has given them some protection from the system and to introduce as much competition market power of the generators. But because as possible demanded the creation of entirely the price cap formula allows them to pass new market forms for the industry. So some of through all costs of purchasing electricity, they the reforms are still under way. Shifting to an have a weak incentive to seek the cheapest open power pool with continuous bidding and source of supply, despite their obligation (to introducing retail competition in the second-tier the regulator) to do so. market, for example, are both highly complex Lessons from Power Sector Reform in England and Wales reforms that take time to achieve, and the op- industry by making it harder for the regulator to eration of these markets is still evolving. identify the true costs of distribution. But a gov- ernment cannot adopt a market-based system The drop in the franchise limit to 100 kW ini- and then expect the structure to be set in stone. tially created severe accounting problems be- cause many potential customers lacked the The use of RPI ­ X price caps in the U.K. system special meters required to trace their usage has already yielded substantial experience. Price through the day. Introducing retail competi- cap regulation was chosen to avoid the lack of tion in this segment of the market appears dif- incentive to reduce costs in a cost-plus (rate-of- ficult if, as in England and Wales, the regulator return) regulation formula, and the regulatory is not given the responsibility and power to process was designed to give the companies an oversee expansion of this market. Metering is assured period between regulatory reviews in expensive, and the cost may not be worth it which to look for cost savings greater than the below 75 kW. Despite the vertical integration X factors. But the regulator has been forced to between transmission and distribution and be- intervene between scheduled reviews and to in- tween distribution and supply, there is no evi- vestigate the actual and potential returns to capi- dence that distributors hindered second-tier tal for the companies, moving the system toward access to consumers in their region. This sug- the criteria used in U.S. rate-of-return regula- gests that here the regulatory threat was effec- tion. The initial failure to set a reasonable price tive--though possibly because the RECs did cap for the distributors has proved expensive not wish to draw attention to their profits. for the consumer. Moreover, subsequent ex- perience with setting price caps shows how As it turns out, new investment in generation difficult it is to correctly assess the level of pro- has been slow to have an effect on competi- ductivity that can be obtained in the distribu- tion, and the dominant generators still have tion sector. Prices have fallen relative to costs, This series is published considerable market power. Partitioning the but few of the efficiency gains have been to share ideas and invite sector into smaller units and reducing the mar- passed on to consumers. Only time will tell discussion. It covers ket share of the largest generator at the time of whether this problem is transitory or reflects a financial and private sector development as privatization would have helped create com- basic weakness. Given the tendency toward well as industry and petition faster. Changing the structure of the large profits in the system, a form of regula- energy. The views industry or the general rules of the game after tion that provides a formula for sharing exces- expressed are those of the authors and are not privatization is extremely difficult politically, sive profits with consumers may well emerge. intended to represent because purchasers accept the terms of the an official statement of privatization on the basis of the status at the The regulator has come under enormous pres- Bank policy or strategy. time of privatization. Shareholders inevitably sure. He has been made a scapegoat for sub- Comments are welcome. would claim that they had been cheated. optimal decisions made by the government at Please call the FPD the time of privatization, a predicament illus- Note line to leave a message (202-458-1111) A striking trend in the system is the movement trating the need for a strong and independent or contact Suzanne toward reintegration. Market forces are pushing regulatory commission. The regulatory reviews Smith, editor, Room distributors to consider merging with one an- show the difficulty of the regulator's task. Each G8105, The World Bank, 1818 H Street, NW, other, to ward off threats of takeover from out- REC assembled its own regulatory team and Washington, D.C. 20433, side the industry by taking advantage of produced massive documentation to support or Internet address economies of scale. Vertical reintegration is also their own assessments of the desirable price ssmith7@worldbank.org. occurring as distributors purchase their own caps. The relatively small size of the regulator's 9Printed on recycled generating capacity. In addition, one of the gen- office and its broad responsibilities clearly paper. erators is bidding to acquire a REC. The take- worked to the advantage of the companies. over movement, inevitable in mature stock markets when large profits are visible, will sub- Robert Bacon, Oxford University, Oxford, England stantially complicate the formal regulation of the (email: econ46@vax.ox.ac.uk)