Sir Ian Byatt on the Past, Present and Future of Energy Market Regulation


Sir Ian Byatt

The following is based on a presentation given by Sir Ian Byatt at a Future Energy Strategies Seminar on the 12th November 2013.  Future Energy Strategies is most grateful to Sir Ian for additionally contributing a written version of his talk to us to publish on our website and here it is.

“There is a crisis, not only in energy policy, but in the regulation of energy utilities. Government energy policy, based on the bi-partisan Climate Change Act is rapidly raising prices to customers, and mandating massive investments of doubtful utility.  Politics rather than economics is driving policy; Ofgem has ceased to be an independent regulator and has become an agent of Ministerial policy.

Things could get worse.  The furore over bills is encouraging policy making on the hoof at a dangerous time when an election looms.

Some history

Looking at the past may help us better to speculate about the future, and to adapt our regulatory and policy-making arrangements to developing circumstances.

Energy has always been of critical importance to the economy.  Coal was one of the pillars of the Industrial Revolution.  Happily, the development of coal mining in the late 18th and early 19th Centuries took place when there was a revulsion against trading monopolies, against Guilds,  and generally against restraints of trade.

When gas & water utilities developed in the early C19, Parliament tried to rely on competition alone.  But, all too often, initial competition was followed by a price agreement.  Parliament sought to limit profiteering, by maximum prices and statutory limits on dividends.  Gas prices were eventually “regulated” by a dividends: price sliding scale, whereby increases in dividends were linked with price reductions for customers.

There were many complaints about inefficiency and poor service.  By the mid-C19, many of the big municipalities had bought, and were operating, gas & water supply – proud of buying out private monopoly, and proud of reducing both costs & prices, and of improving service to customers.  Their success fuelled the rising tide of municipal enterprise and, subsequently, as economies of scale developed, of state enterprise.

By the 1880s, when electricity utilities began to be formed, Parliament extended the new franchising arrangements, that had been devised for horse tramways, to electric light companies.   Prospective undertakers were to apply to the Board of Trade (BoT) for a Provisional Order to run  for 21, subsequently 42, years, after which time, local authorities could buy the undertaking compulsorily at the plant value.  The Act also laid down a standard maximum price of 8d a kWh.

The BoT interpreted the 1882 Act as giving preference to Local Authorities over companies, providing that they did not block the activities of a company by holding and not proceeding with powers.  By the first world war, most of the big towns – outside London and Tyneside – were supplied by municipal systems, while country areas – and London & the North East were supplied by private systems.

Although the belief that competition was the sole necessary regulator had gone, it was still allowed a role.  In 1889, the BoT authorised two electricity distributors in each of the areas of central London so that customers could have a choice between dc and ac systems.

In the early C20th, growing economies of scale, based on  success of the technological innovations pioneered by Ferranti, Parsons & Merz, and first applied on a commercial scale in the north-east, led to the promotion of regional power companies.  They had to seek, through private Acts of Parliament, powers to compete with existing companies.  While Parliament was often disposed to grant the requisite authority. it was loath to remove existing powers unless those risking their money had received fair remuneration, particularly when they were local authorities.

Results were mixed; while efficient supply spread in the north east, the situation in London was confused as a result of political conflicts.

Developments in the interwar period, were in organisation, technology and investment rather than in regulation.  Electricity Commissioners were set up to co-ordinate the operation of different suppliers.  A Central Electricity Board was formed in 1926 and the first national grid (essentially a set of regional interconnection schemes) developed.

But in the 1930s there were still more than 600 franchised electricity supply operators.  And in gas supply remained fragmented.

At nationalisation, a British Electricity Authority was created to operate generation and main transmission and to exercise a controlling authority over 14 newly established Area Boards.  Gas was similarly nationalised, but as one organisation.

Regulation was to be on Morrisonian lines: these bodies were to have Boards that protected the public by taking account of both social and commercial  objectives.  Trade-offs were for the Board, not for Ministers, except under powers of General Direction, which were never used.

Nationalisation did not serve customers well.  Operations were inefficient – on a massive scale.  Capital was wasted, particularly in nuclear generation, where we tried to develop our own technology in the form of AGRs, some of which worked and some of which did not, but were all were expensive.  Boards were subject to covert political interference to meet social and macro-economic objectives, damaging financial control.

Three major White Papers, were issued, in 1961, 1967 & 1978.  Ministers, however, took little notice of them; political objectives dominated.

The first crack in the monolithic structure was Nigel Lawson’s introduction of contestability in electricity supply.

Privatisation in the 1989s brought big benefits.  Privatised companies could concentrate on business objectives.  RPI – X price control created high-powered incentives for greater efficiency and better use of assets.  Companies were exposed to capital market disciplines.  The vertical break-up of the CEGB and of British Gas facilitated competition in generation and supply.  Prices to customers fell.

This took considerable courage on the part of both Ministers and regulators.  It was not easy for Mrs. Thatcher to break up the CEGB after the help that Walter Marshall had given her during the NUM strike.  It took courage for the MMC and Ofgas to achieve the breakup of British Gas under the formidable Dennis Rooke.  At Offer, Stephen Littlechild ingeniously extended the number of competitive generators.

The impact of an active energy policy

But now all this has been disrupted.  Energy policy has been resurrected in the guise of an activist climate change policy.  Moreover this policy has not been applied through market signals, but by government decisions on the type of electricity generation, which then generate incentives through high feed-in tariffs.

Estimates of the effect of green taxes on electricity prices have emerged in recent weeks.  But they seem not to include the cost of the massive reinforcements to the grid that will be required if there is to be growing reliance on renewables.

A credit card  (RIIO) has been invented, whereby Ministers can devise policy, covertly to be paid for by customers.  They have been much more concerned with financing than with appraisal of investments.

Ofgem has abandoned any pretence of working through the market.  It is the duty of an independent regulator to alert customers to price shocks; but when Ofgem tried to do this, it was told to keep quiet; and it did.

Not only is energy policy is at the cross roads; so is regulation.  I used to think that regulation could introduce more objective analysis into decision taking,  and believed that independent regulation could enrich public policy by introducing a new separation of powers.  Now I fear that this agenda is in reverse.

Rather than searching for guilty parties, we should step back, to see clashes in objectives.  One of Ofgem’s objectives was to make the energy market work better by introducing competition.  This becomes an impossible objective when ministers want to over-ride the market – especially when government is pursuing two conflicting, and unresolved, energy policies, one to switch to renewables and the other to encourage fracking; the all-too-familiar spectacle of government with its feet down hard on both the accelerator and the brake.

Ofgem (or is it Ministers?) seems to be contributing to the problem by trying to manage competition by insisting on standard tariffs and preventing companies from developing better deals.  So far this has had the unfortunate effect of raising rather than lowering the retail margin.

What of the future?

Are there lessons to be learned?

I suggest four political ones, and three technical ones.  My list, at the political level, is:-

• Ministers should not intervene without setting out – and consulting on – all the consequences of their policies.  They must be honest about the trade-offs that must be made.  If we are to have a well-functioning market economy, Parliament must strengthen its position and properly challenge ministers.

• Energy policy should be properly clarified in ways that are operationally sensible.  This involves taking an intelligent position on climate policy and traditional investment appraisal, not simply considering methods of financing.  There are issues of modalities as well as objectives; a carbon tax, e.g. would combine policy on emissions with market incentives

• Ministers should recognize and respect the importance of business time-scales, the independence of regulators and the accountability of transparency.

• It must be recognised that Malthusian predictions concerning future energy shortages have proved systematically wrong, – from Jevons, through the Club of Rome to modern environmentalism – and have always been unhelpful to rational policy.

At the technical level:-

• in network industries, with significant monopoly/oligopoly power, some combination of regulation and competition is necessary.  This balance will depend on the situation

• Competition and regulation may not be a simple trade-off.  When competition for non-household customers was introduced in the Scottish water industry, it worked within a default tariff, namely, the regulator set a tariff that was available to all customers, but which competitive retail suppliers could beat.

•  We should  look closely at how competition has worked in different situations so that we can speculate more precisely about the consequences of relying on it. We can draw on experience in a number of situations since the 1980s.

We cannot expect progress to be fast; but we have lost a lot on ground since the 1990s.  Those involved should all explore ways it can be recovered.

Thank you for listening to me.  I look forward to our discussion and your views on both the situation and how it could be reformed.”

London 12 November 2013                             Ian Byatt

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