Since the privatisation of the British electricity industry in the early 1990’s the power industry has gone through major structural changes. As with most privatisation of former public companies, (such as the privatisation of British Telecom and British Gas), the government wished to see increased efficiency in the production of electricity.
By privatising, the government hoped that the incentive of higher profits would act as a reward for efficiency, meaning that more effort would be made in research and development of new techniques so as to make production more efficient. In order to pass savings onto the consumer, the electricity companies would have to work under certain restrictions imposed by the government and the electricity regulator, (OfGen), which were designed to prevent private monopolies exploiting the consumer.
The aim of this project is to investigate to what extent the industry has changed since these changes were implemented and how the price of electricity to consumers has been affected by these changes.
The privatisation of this industry has seen four main stages:
Firstly, British Electricity, a government run industry which was effectively a public monopoly ran from the 1960’s until the first step to privatisation in 1990. This stage on the road to privatisation was to introduce competition in direct supply for customers with over 1MW in demand (around 5000 sites), thus introducing the idea of competition into the industry, allowing a small proportion of the market to be run to a certain extent by the market mechanism.
In 1994 the threshold level above which competition was allowed was reduced to 100kW which added another 50000 customers to the competitive industry, meaning that approximately half of all demand for electricity was subject to competition.
By 1995 the regional electricity companies were in full existence and were in the position of having a private monopoly in their particular region, especially as the regional companies were now able to sell to larger markets as the companies had now become the sole providers of electricity in their own particular areas. This effectively meant that in a particular area each different company was in the position of having a private monopoly (although this was regulated by the government).
However, in 1997 this situation changed for good, as it had been realised that the monopolies had not introduced new technologies or lowered prices for consumers (as the privatisation had been intended to do) but had simply led to the exploitation of consumers. This was because the government was not regulating the companies well enough, and because they faced no competition in their own regional area, they could afford to become less efficient and so not providing the benefit to the consumers which they had been intended to do. By 1997 it became clear that the government had to intervene into the market and at this point de-mutualisation came into existence. This meant that from 1997 any customer in the UK could buy electricity from any of the other regional electricity companies.
The question that I wish to answer is: –
To what extent did the restructuring of the electricity industry in the 1990’s affect the price of electricity to consumers and for what reasons did this occur?
The market for electricity in the UK has undergone several important structural changes as outlined in the introduction to the coursework. Initially, before privatisation, the electricity market was a public monopoly which meant that although it had all of the features of a monopoly it was controlled and owned by the government and thus it was intended to provide the best price for the consumer. However, the idea of privatising the industry was that the extra competition found in the market would allow the consumer to see a further fall in price, particularly as the competition should have increased finance of research and development and therefore increased efficiency in the market.
However as competition in direct supply between the regional electricity boards in all areas became legalised the market has taken the form of a new, competitive market. Thus since the beginning of privatisation in the early 1990’s the market has seen a transformation from public to private monopoly and then to a new market type. This can be related to the three main types of economies; namely the planned/command economy, the mixed economy, and the free-market economy. In fact, when the government ran the electricity market, it fitted into the planned economy in which resources are allocated by the government. Since privatisation though, when the electricity industry has bee competitive it could be said to be run as a mixed economy would be – effectively free-market competition with government controls to try and ensure equitable behaviour by the electricity generators.
By examining the features of different types of market structure as follows, I hope to establish what type of market the British electricity is based upon.
Monopolists have a 100 percent market share (in theory – in practice a monopoly needs 25% share) and thus they face the market demand curve, as they are the only firm operating in the particular market. Monopolists are therefore constrained by the level of market demand at a particular price or by the level that consumers are willing to pay for a product at a given output. Monopolists can thus choose the output or the price level at which to produce but they cannot determine both. The monopolist’s demand curve (AR) is shown below, and the diagram also includes the monopolist’s marginal revenue (MR line as well as the monopolist’s marginal cost curve (MC).
The conditions necessary for monopoly to exist are:
1. A 100% market share ( in real life a 25% share is deemed to be monopoly)
2. No close substitute products ( thus giving relatively inelastic price elasticity of demand)
3. The monopolist is a short run profit maximizer
4. There are barriers to entry to prevent new firms entering the market
The monopolist is assumed to be a profit maximizer and therefore charges at the profit maximising output at the point where marginal cost (MC) cuts marginal revenue (MR) and therefore the firm charges a price of Pm and produces an output of Qm. In this case, the cost of the marginal unit is therefore equal to the cost of the marginal unit and so the firm is maximising profits. However, to look at the profits we add the average total cost curve (ATC) on to the diagram. The level of abnormal profits made by the producer in this case are shown by the vertical distance between ATC and price multiplied by the quantity produced. This is shown by the shaded area below:
The conditions needed for perfect competition to exist are as follows:
1. Many buyers and sellers operating in the market ;#8211; therefore no individual can control price or output decisions
2. Homogenous products ;#8211; the products on the market are perfect substitutes for each other. This means that no brand loyalty exists and therefore the consumer makes purchasing decisions solely on price
3. Transport costs do not exist ;#8211; the product has the same price everywhere
4. Consumers have perfect knowledge and know all prices and can thus buy at the lowest price available to them
5. Firms have freedom of entry and exit to the market ;#8211; losses cause firms to leave the market whilst profits attract new firms
6. No government intervention into the market
7. The consumers’ aim is to maximize satisfaction from a limited income. The aim of the firm is to maximize profits by charging the highest available price
The equilibrium price in a perfect market is at the intersection of demand and supply, as shown on the following graph.
At a given moment in time, given that the conditions of supply and demand are being held constant (ceteris paribus), when the market demand and the market supply are plotted on the same graph an intersection will be created. This point of intersection is known as the equilibrium point, at which the supply and demand of the product are balanced and there is no need for a change in either price or output unless a change of market conditions dictate otherwise. The price is set at P* and the output is set at Q*.
Oligopolists are situated in between the monopolistic market and the perfectly contestable market. Whilst perfectly competitive firms are often known as ‘price takers’;, and monopolists re known as ‘price makers’;, oligopolists are known as ‘price searchers’; because they change their price according to the prices of their rival firms. The conditions of oligopoly are as follows:
1. A few large firms must exist in the industry. For example, a small number of firms have around a 90% market share
2. Products must be branded to the extent that consumers are willing to pay more for a product which they consider superior
3. Barriers to entry must exist within the market. These could include artificial barriers to entry such as legislation or natural barriers such as high start-up costs
Oligopolists have a kinked demand curve because the theory assumes that oligopolists will assume the worst case scenario about their competitors reactions to a change in price. In the diagram below, if the oligopolist raises its price from P* to P1 then its competitors are unlikely to react in the same way and will therefore undercut the firm. If the firm should choose to lower its price then the other firms are likely to follow with a similar price change. For a rise in price, demand is elastic because consumers can buy the product from any of the other firms which are still selling their product at the original price. Conversely, a fall in price will see an inelastic change in demand because the other firms in the market will imitate this fall and so demand is unlikely to alter. This is shown in the following diagram:
As shown in the diagram, the demand curve above the kink has elastic price elasticity of demand whilst the price elasticity of demand is inelastic below the kink. This means that for a price rise, demand is elastic, whilst for a fall in price, demand is inelastic.
Which type of market structure has the electricity industry follow through the transition of privatisation?
From 1994 the electricity industry clearly show the feature of a monopoly. In each region of the country, consumers can only buy their electricity from one firm – namely the regional electricity company. Electricity certainly does not have any close substitute products which means that the industry fits another of the key characteristics of monopoly during the early 1990’s. The final characteristic of a monopoly is that there must be barriers to entry to prevent any other firms entering the market. In the case of the electricity industry, the government itself was responsible for keeping the monopoly in place and this was a legal barrier to entry.
Since the change in the industry in 1994 at which point consumers have been able to buy from any of the regional companies the market has itself changed from a monopolistic market. It has certain features of a perfectly competitive market ;#8211; for example, there are many buyers or sellers, electricity is a homogenous product, there are no transport costs, consumers have perfect knowledge, and the fact that consumers are aiming to maximize satisfaction on a limited budget. However it does not comply with several of the key features of a perfectly competitive market. Although electricity itself is a homogenous product, people are also paying for a service for example a good, constant supply. Consumers also have a brand loyalty as the regional companies have their own brand names and advertising. Firms do not have freedom of entry and exit to the market either ;#8211; just as existing firms are protected by the government (an example of government intervention) from new firms entering the market, firms are contracted to provide electricity for the region for a period of time, during which the government will also regulate the price which the firms are charging. For these reasons, the electricity market is clearly not a perfectly competitive market but contains many features of an oligopolistic market.
The industry is in fact an oligopolistic market ;#8211; there are a few large companies which dominate the industry, branding does exist to the extent that consumers are willing to pay more for a product which they consider to be superior – hence the advertising campaigns which are visible on billboards and on television countrywide. Finally there are barriers to entry in the market (such as branding as the huge start-up cost of generating which stop firms entering and exiting the market. Since 1990 therefore, the market has seen the change from monopoly to oligopoly. In effect it is now a free market, although this is slightly distorted because of the human behaviour which means that many people have chosen to stay with their own regional company because they are reluctant to change.
In order to look at how the privatisation has affected the price of electricity to the consumer I need only to look at one particular region because each region was, until de-mutualisation, effectively completely independent from all of the other regional electricity areas with the simple exception that all areas were governed by the consumer watchdogs. Thus, the figures needed to study the effect of privatisation need only come from one region. I have selected to study how prices have changed in the SWALEC electricity region as this is a relatively large region (in terms of customers) and also is one of the regions in which any regional company can now sell electricity.
To find out the price information from SWALEC I e-mailed the SWALEC customer services department and requested pricing information from them, to include the prices per customer of a standard usage over the period of the last few decades, as well as a price list for SWALEC’s prices in other regions compared to that regional company’s price. I received this information and I then used it to collate the information into the form as shown in the presentation of findings.
Presentation of Findings
This table shows the actual cost in the period 1986 ;#8211; 1999 for an annual electricity supply (3300kWh):
YEARANNUAL BILL ()
This data is also represented in the following graph:
The next stage in the analysis of the data is to index the figures using a bases year so that it is possible to compare the figure as real values. In order to do this the percentage change between each year and the base year are calculated and this figure is then added to the index for the base year. (NB. this is possible only because the base index is one hundred and the figures changes are in percentage form). The index is as follows:
YEARANNUAL BILL ()% Change from base year( – )Index
This index can also be shown graphically:
SWALEC prices in all regional areas are shown in the following table, as well as the price that the regional provider charges in each of these areas. These figures are the latest 1999 supply rates:
SWALEC TARIFF()REGIONAL TARIFF() DIFFERENCE()
Analysis of findings
The question that I wished to answer was as follows:
To what extent did the restructuring of the electricity industry in the 1990’s affect the price of electricity to consumers and for what reasons did this occur?
This question can be answered in sections; namely,
1. What effect did the original privatisation have (until 1994)?
2. What effect did the regional monopolies have (1994-1997)?
3. What effect did demutualisation have (1997onwards)?
Analysing the effect of privatisation pre-1994 was made far simpler by using the table of indexed prices which means that all of the prices can be compared like for like, and then shown in a graphical form as shown:
The graph clearly shows that prices are rising steadily up until 1989/1990 at which point as explained in the introduction to the project, the price starts to rise sharply until 1992, at which point it stays at a steady level until around 1994 (the second stage of privatisation). This shows that the original privatisation did have an effect on the real price of electricity to consumers – namely, that the price rose from the index price of 60 to 100 in 6 years. This shows a real price increase of 10% per annum. However the largest rise in the cost of electricity was from the start of privatisation in 1990 until 1992 when the cost of electricity rose sharply from 80 p.a. up to 100 over a two-year period. This increase is caused because the initial stage in privatisation from British Electricity that was supposed to lead to an increase in competition actually led to a private monopoly taking over a public monopoly, in the form of a duopoly between PowerGen and National Power. As neither firm was large enough to take over the entire electricity market, the effect was that both firms had a natural monopoly (legally enforced) which allowed the companies to increase prices.
The duopoly held by the two firms has seen the use of the games theory by both of the firms in the market. The games theory is summarised as follows:-
In a given market, the actions of one large firm directly affect the strategy employed by the other firms in the market, and thus neither firm is willing to push prices up too high for fear of being undercut or push prices down for fear of bankruptcy. In 1991, when national power and PowerGen took over the UK industry, they were able to increase prices at equivalent levels and both stay in business, whilst still increasing prices and therefore profits. This increase in price by the duopolists led to an increase in the price of electricity for SWALEC and this meant that the cost to the consumer also rose as seen by the price index (above). Up until 1994 the price of electricity rose – although the government had not expected this rise they did not intervene into the market until 1994, and so the change in price until 1994 was as expected by the application of economic theory. The profits of the electricity generators also rose over this period, as shown in the following table:
The next stage of privatisation was from 1994, at which point the government intervened in to the electricity market. It had been realised that the electricity prices in the early 1990’s had often been higher than was hoped and so the industry regulator imposed restrictions onto the electricity generators and imposed a maximum price of 2.4p per kWh on the price of electricity over the next few years.
Theoretically, maximum price impositions were intended to make electricity more affordable to the consumer as well as limiting the returns that the electricity producers were able to make. In the above diagram, P*Q* represents the original price charged by the generators and P1 shows the new maximum price which was charged by the generators. Q1 and Q2 are the demand and supply levels taken when the price is set at the new maximum level. In the short term, this maximum price helps to solve the problem caused by the generating companies’ over-pricing. They continue to offer Q* of electricity and so the distributors (such as SWALEC) are able to buy this electricity at the lower price and therefore lower their prices as well. However in the long term, with the new maximum price imposed, the supply is set at Q1 and demand increases to Q2 and so the market faces excess demand. For this reason, if the regulators had imposed maximum prices alone then the excess demand would have caused failure in the market. To avoid this, the regulators also imposed another measure – they changed the rules that governed the distribution boards’ price formulae. Until 1994, the pricing formula allowed the distributors to move prices up according to the level of inflation, a formula that led to the distributors making huge profits. However in 1994, this formula was altered to the RPI ;#8211; X formula still in place today which meant that the companies could increase prices only by the level of inflation minus a figure which depended on the level of profits made by the particular company. Furthermore, all of the distributors agreed to cut the price of electricity to the consumer by between 11% and 18% (SWALEC reduced their own prices by 12.5%). This caused a real fall in prices of SWALEC electricity until 1996, as shown in the graph showing an indexed price of electricity (p10).
The third stage in the privatisation of the electricity companies was from 1996 until 1999. This transition saw further restrictions imposed by the electricity regulator, as well as the demutualisation of the regional companies that led to the beginning of an oligopolistic market structure. Between 1996 and 1999 the price of SWALEC electricity reduced further from almost 100 per annum to 80, a significant fall. The cause of this fall in price is twofold:
Firstly, the pricing formula used by the electricity distributors, was reviewed and changed so those prices would fall by 10 and 13 per cent during 1996 (real terms) as well as the falls that were implemented in 1996.
The second reason for the price reductions over this final period of privatisation was the demutualisation, which was taking place at the time. Demutualisation meant that the structure of the electricity industry had once again changed significantly. The new structure of the industry meant that all regional electricity companies were able to sell electricity to consumers living all over the country ;#8211; not just those in their respective regional area. This meant that the electricity market changed from being a set of private monopolies to being a national, oligopolistic market. The conditions of oligopoly state that all companies are interdependent and so therefore any pricing decision or strategy taken by one company within the market will lead to similar price movements within the market. According to theory, this would have seen one price charged throughout the market by all companies and thus led to a fall in price for the consumer (because all companies would thus have to reduce prices at the rate as enforced by the regulator).
However, in practice, this did not happen, as shown by the table below, which shows the difference between regional tariffs and SWALEC prices in each region:
SWALEC TARIFF()REGIONAL TARIFF() DIFFERENCE()
The average price difference is 5.35. This means that on average SWALEC prices in regions around the country were 5.35 less expensive than the regional companies’ prices in their own regions. The other important statistic from this table is that SWALEC charged the most for electricity within their own region. Obviously, this does not fit in with the theory of oligopoly, as the equilibrium price should be established by the pricing decisions of the firms in the market and then this price should be fixed for all market firms until one firm tries to undercut their rival firms or push up their prices to increase profits. The important question is why SWALEC charge more in their region then in any other reason without losing custom and going out of business. The reason for this is that the theory of oligopoly (and all other theories of the firm) states that the firm aims tom maximise profit and the consumer aims to maximise satisfaction and minimise cost. The problem with this theory is that the consumer will not always take the trouble to save themselves money when the saving is minimal. In terms of the electricity industry this is reflected in the fact that SWALEC can charge a higher price on average in the SWALEC region, knowing that the inertia of customers to change to another company for a relatively small saving will allow them to charge this higher price and still make high profits. This can be put more simply in economic terms – the price elasticity of demand becomes more inelastic as consumers have to spend their time in saving money. It can safely be assumed that all of the electricity companies can charge higher prices in their own areas, charge lower prices in other areas to try and ‘steal’ customers from their rivals and still make high profits. This has meant that the price of electricity has again fallen between 1996 and 1999 but not to the extent that the regulator had tried to enforce in 1996. However, the latest review of the industry by the regulator (OfGen) suggests that prices may be forced into falling by up to 25% in the future.
Evaluation of findings and research
The findings of the project have shown that the restructuring of the electricity industry has resulted in a rise in real prices over the first half of the 1990’s as well as a decline in real prices over the second half of the 1990’s. It is clear that these price changes have been as a direct result of the changes within the industry, as well as an indirect result of these changes in the form of government intervention into the markets. The changes in price can therefore be put down partly to the theory of the form. During the early stages of privatisation, the monopoly held by the electricity distributors meant that they could push up prices and not affect the demand from the market, thus pushing up their profits. This is because theory of monopolies can be used to show that this price movement is possible when the demand for a good is relatively price inelastic. Electricity, a good with no close substitutes fits into this category. The second main stage of privatisation saw the price of electricity falling as the change of the market into oligopoly saw prices falling as a result of competition in the market. This then led to prices falling in real terms, partly due to the competition in the market and also due to the regulations imposed on both the electricity producers and the distributors, both of which led to reductions in price.
I believe that the research during the course of the project has shown the change throughout the 1990’s very well but I think that given more time, it would be possible to improve the project. One area in which the project could be improved would be to increase the volume of information available to use in the research, but unfortunately public companies are not always forthcoming in releasing confidential financial information to the public. Information about the regional electricity companies’ growth during the period would be especially useful in looking at how the companies had profited at the expense of the consumers. Regulator reports looking at the fairness of the companies’ growth and pricing strategies would also be particularly useful, but unfortunately these are not public documents. Even given this extra information I believe that the result of the coursework would be the same, and would explain the changes in price of electricity in the same way. From the project I have been able to explain and evaluate the changes in the UK electricity industry and also look at the price strategies of companies in the different areas of the country. I would advise anyone thinking of changing their electricity supplier to look at the cost of electricity from all of the regional suppliers, but I would expect that they would find all of the other companies to be cheaper than their own original supplier. I conclude that the industry has changed greatly over the 1990’s and that the industry may well continue to change as the regulator becomes more involved in the industry.