Expert view: Trevor Loveday

“A full investigation into the energy market could throw light on to things that neither government nor regulator nor the opposition want to see illuminated”

Politicians. Their capacity to get things wrong and to then disguise their failures with spin are the stuff of legend and the basis for some of the best TV comedy of the past 30 years. Thankfully, wayward paths taken by governments of one colour tend to be righted by subsequent elections – even if the correction usually takes things off in a different wrong direction. Where things become alarming is when subsequent administrations choose to plough the same furrow as their predecessor. Energy policy, for example.
Energy secretary Ed Davey’s suggestion that the regulators need to “think radically” and the break-up of British Gas might be a good place to start is the latest thrown chair in the bar room brawl that energy policy has become. If anything needs to be broken up, a better starting place might be the existing electricity trading arrangements, which have been left virtually unscathed by the Energy Act. But the truly worthwhile move is hardly radical but probably more scary to all involved.
The brutal truth is that the power companies are doing what any private sector company with shareholders has to do – maximising profits within the rules of the market. Their exploitation of the market rules that allow them to protect their position through vertical integration is an option they have been gifted by government.
Tony Blair’s first Labour government reformed the electricity trading arrangements to knock out what was a transparent and liquid market based on a system marginal price – the Pool – in favour of a pay-as-bid bilateral trading system. The drivers behind this were entirely political and misinformed. The reform followed intense lobbying by energy-intensive industries who were not seeing the benefits of competition. And indeed wholesale prices under the Pool remained unchanged in its decade of operation because of the ­market power in the hands of the original duopoly ­created by privatisation. Politicians had been ­convinced that the market power was a product of the Pool when the issue was one of governance.
The Pool was unnecessarily complicated, as were the implications of a bilateral trading system. A succession of energy secretaries missed that the inevitability of the New Electricity Trading Arrangements (Neta) was that generators would seek to secure markets for their output and snap up suppliers to become vertically integrated entities. The prospect for competition induced by new merchant plant was slim.
There were clues that the politicians chose to ignore: first there was the generators’ abundant enthusiasm for the reforms. Second there were experts yelling “don’t do it”. Professor Stephen Littlechild, the chief architect of privatisation, warned: “Sufficient case has not been made for significant changes to existing arrangements so as to allow widespread trading outside the Pool.” Energy economics heavyweight professor David Newbery in 1998 said the review of electricity trading that produced Neta “appears to have relied mainly upon unsubstantiated claims, inappropriate analogies, unquantified criticisms, and a remarkably uncritical assessment by the participants of the debate, without commissioning the kind of detailed analysis one might have expected from a regulatory agency claiming industry expertise”.
Experts at the time questioned the apparent assumption that the market price under the new arrangements would provide long-term signals to build new capacity. In truth, the long-term investment issue was probably overlooked given that the new arrangements came into play amid a glut of capacity created by a rush of new gas-fired power stations. The overcapacity brought wholesale prices down, which made heavy consuming industries happy and vertically integrated power companies took higher margins to offset the upstream losses.
So here we are with vertically integrated companies with opaque retail prices that nearly 20 regulatory investigations have failed to address. The need for new capacity has reached crisis point and there is no market incentive to invest in capacity. The need for government intervention is, and always has been, compelling.
A competition authority referral is needed, and has been for some years. But it is unlikely to happen, although a former high-ranking and astute member of Ofgem’s policy team, Stuart Cook – now with PwC – believes Davey’s letter to Ofgem and the competition authorities suggesting radical action against the main energy players has brought a competition referral nearer than ever.
But the likelihood is slim because were the Competition and Markets Authority to delve into the energy market, it could throw light on to things that neither government nor regulator nor the opposition want illuminated. It could show how decisions to reform the market were ill-conceived and possibly political driven. It could expose the true costs of subsidies for renewables and nuclear, which could spark awkward moments for government and opposition. And it may well beg questions about what the regulator has been doing for 15 years.