The liberalisation of power markets and its effect on investment

When we are thinking about why it seems so difficult to take necessary decisions in the field of energy now compared say to the 1950s or 1960s, it is helpful to consider what is meant by a ‘decision’ and who might be responsible for taking it.

From the great nationalisation programme of the late 1940s to the great privatisation programme some 40 years later, decisions in many fields which were of considerable importance to the economy and which required large capital programmes were taken directly or indirectly by the government of the day. UK government and its agencies were responsible for steel, for telecommunications, for gas, electricity and large parts of the oil industry, for a proportion of motor car manufacture, for the railways, airports and the national airline.

In such an environment, taking a decision was in principle a relatively straightforward affair. The relevant government department would take a view as to the national interest in the field involved and weigh up the various projects that might deliver it, against the background of the Treasury acting as an arbiter of the dreams and desires of the different departments within the context of what the nation could afford. Although the agencies of government - British Telecommunications, the British Steel Corporation, the British Gas Corporation, British Leyland, the Central Electricity Generating Board, British Aerospace, British Sugar Corporation, Cable & Wireless, Britoil, BP and so on1 - would have a certain amount of responsibility and therefore autonomy over how to deliver the national policy (and would take much of the flak if things did not work out), the will of the government would usually prevail.

Of course reality was not always quite so simple. Other agencies in society, for example powerful trade unions, may have different interests coupled with the political or industrial power to make things difficult. Many of the industries were led by individuals with a long history in the business, leading perhaps to something of a technocratic mindset and a sense of being product-oriented rather than consumer-oriented, the nuclear industry arguably being a particular example. In practice these nationalised industries were often subjected to heavy political interference depending on the policies or whims of the government of the day. Furthermore, when investment was necessary the agency in question would find itself in a queue competing with other government projects for funds, some of which may have a more rapid or greater political payback in terms of popularity, or avoided unpopularity, and hence of votes. Nonetheless, the lines of strategic and operational responsibility and accountability were reasonably clear and the government of the day could be judged on the success or otherwise of the projects involved.

For a variety of reasons, this centralised approach to decision-making was largely supplanted by a market-based approach as large nationalised industries were broken up and sold off, especially in the 1980s. State-owned monopolies in particular came to be regarded as inherently inefficient. Being shielded from competition they tended to become complacent and lack innovation. Being backed by government money the agencies in question were in effect prevented from failing - customers were trapped and government would bail out any financial losses. In extreme cases it could even be in the interests of the companies involved to be inefficient - a major project running over schedule and budget meant more work and wages for the state-employed workforce and their managers. BNFL, the monopolistic state-owned company responsible for the nuclear fuel cycle, contracted its services to the monopolistic CEGB on a ‘cost-plus’ basis, albeit diluted with incentive fee arrangements - in other words it would be paid a fixed rate of return on top of its costs. The higher the costs, the higher the returns. The government was shareholder of both sides of these contracts and took an interest in the relationship, but nonetheless a regime which rewards poor performance with higher profits is clearly flawed. It was only in 1992, more than 20 years after BNFL’s creation, that arrangements shifted to fixed-price contracts with the nuclear generating companies, which though still state-owned were by then competing in a liberalised marketplace and looking forward to privatisation.2

The word ‘privatisation’ was actually used in two senses. The ‘British Telecom-style’ (BT) privatisation involved selling off not only the phones and wires but also the responsibility for providing telecommunications services. If the mobile phone network goes down nobody now blames the government - it is clearly the responsibility of the phone companies. The privatisation of British Steel and the car manufacturer British Leyland were other examples. However, there was also the ‘British Rail-type’ (BR) privatisation, where although the trains and tracks were sold off, the responsibility for the strategic rail network remained with the government, as was demonstrated when network operator Railtrack collapsed in 2002. The government was forced to transfer its assets into a state- owned successor, Network Rail, rather than simply allow it to go broke. Other examples might include the privatisation of the water industry and that of the electricity supply - if the taps run dry or the lights go out the government will clearly be held to account.

The situation is complicated where there is an element of ‘natural monopoly’ about the activity in question, or part of it. It makes no sense to have competing networks of water pipes, rails or electricity transmission wires (Finland once did have two national electricity grids but they were not directly in competition). The level of capital investment would be prohibitive and outweigh any operational benefits of competition. So these activities tend to be treated as regulated monopolies, allowed to make a modest rate of return on investment and to charge more or less fixed prices - often one or two percentage points below inflation to act as a surrogate for the benefits of competition - unless they can persuade their regulator of the need for investment and that it can be done efficiently.

Whether the sale of and introduction of competition into the great state-owned monopolies was a success or not largely depends on one’s political tastes. In economic terms it may be argued that, at least in the early years following privatisation, those areas in which competition was feasible and government did not remain the ‘guarantor of last resort’ were the most successful. This is a fairly typical appraisal a decade or so after the big privatisations:

BT was once memorably described, probably accurately, as the most hated institution in the land ... Today we have better quality of service, more choice and lower prices in Britain than almost anywhere else in the world apart from the US. BT is also at the forefront of international developments in telecoms. Liberalisation and privatisation are the two key causes of this extraordinary turnaround. The lesson seems to be, therefore, that provided privatisation is also accompanied by liberalisation, initial teething difficulties are eventually overcome to produce publicly recognised advances. With water, electricity and rail, it is proving much more difficult to introduce competition into the market, virtually impossible in the case of water. As a result we have had to rely solely on regulation to protect the public interest. This regulation has frequently been seen as wanting. Perhaps more seriously, these industries have embraced wholeheartedly all the worst manifestations of corporate excess.3

Among the first of the major privatisations were British Telecom and British Gas. Each was privatised in effect as a monopoly, which came to be regarded as a mistake, or at least a wasted opportunity. By the time that electricity was privatised at the end of the 1980s the government had come to believe that introducing competition wherever possible was just as important as transferring state-owned assets into the private sector. The National Grid and the local distribution networks were treated as natural monopolies. However, competition could be introduced at the level both of generation and of supply.

Decisions about investment in generating capacity, then, became matters for private sector companies, or at least for companies not owned by the UK government, who were responsible to shareholders. However, the outcome of those decisions were of enormous interest to British society at large.

Normally, as has been understood since the time of Adam Smith, the eighteenth- century philosopher and ‘father of economics’, markets work well because the interests of producer and consumer coincide to a high degree. As Smith famously said in his seminal work The Wealth of Nations: ‘It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest' In principle, and largely in practice, the producer sells at a price where the money they take is of more value to them than the goods or services being sold, while the consumer buys at a price where the goods or services are worth more to them than the money. The actual price, at least in theory, is the one that maximises the benefit to both parties. This is not to say that governments have no part to play: government has a vital role in ‘internalising externalities’, most notably perhaps in making sure that firms cannot use the environment as a free dumping ground and have to cover the costs of any damage they may do, and be prevented from releasing emissions beyond a certain statutory limit. Regulation is also necessary to make sure that companies do not indulge in unfair competition, say by predatory pricing, by buying up all their competitors or by colluding with other firms to keep prices high. But notwithstanding these interventions, in general government can, indeed must, stand back and allow the market to follow its own logic. Effective and innovative companies thrive, inefficient and expensive ones do not and the customer reaps at least some of the benefit of this competition.

However, electricity is different from any other commodity in key senses, which contribute to the difficulty which has beset decision-making in competitive power markets.

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