Energy liberalisation leads to higher prices
Saturday, 27 October 2007
Philip Wright
What is liberalisation of the European Union's gas and electricity markets about? This question is worth asking because the European Commission has been preoccupied with how liberalisation needs to be introduced, rather than with its purpose.
Last month, this preoccupation reached fever pitch as a long-awaited package of proposals was adopted by the Commission, including a requirement that the EU's big energy companies should unbundle their gas and electricity networks from their supply businesses, either by establishing fully independent system operators or by way of complete ownership separation.
But what is liberalisation expected to achieve? A more competitive and transparent market and thereby lower prices is the stock reply. A possible relationship between liberalised markets and security of supply has been a more recent emphasis.
Such aspirations could be dismissed on the grounds that the gas and electricity industries are inherently unsuitable industries for competition. Here, though, I would like to challenge them by drawing attention to the impact of liberalisation on the three main cost components that make up the prices paid by households, which, since July, have seen their right to switch supplier extended throughout the EU.
These costs are the wholesale cost of gas and electricity, the cost of transmission and distribution and the cost of supply (billing and marketing).
The impact of liberalisation on wholesale costs is problematic in that short-term markets increasingly price electricity or gas delivered under long-term contracts. Such indexation to short-term markets (for example to month-ahead or day-ahead prices) is wrongly seen as a virtuous indicator of liberalisation, when in fact these markets establish a volatile flexibility premium as buyers and sellers seek to balance their positions when delivery day approaches and options increasingly diminish.
To counterpose them with "old-fashioned" long-term contracts and allow them to set a price for baseload supplies contracted for perhaps years in advance of a delivery day is therefore misplaced - such long-term supplies are more appropriately indexed to a wider basket of commodities, including alternative fuels, in order to reflect the different risk profile they offer. This is not a trivial matter: gas indexation has ruined otherwise viable businesses in the UK and made long-term investment decisions hazardous. The cost of transmission and distribution can account for as much as 30 per cent of prices to domestic customers. However, these costs are not directly affected by liberalisation: they are regulated costs.
This leaves the impact of liberalisation on domestic supply costs - which is a specific consequence of retail competition.
It can be observed with some precision using UK data. Coupling British Gas's supply cost data* with what the UK's Department for Business, Enterprise and Regulatory Reform tells us are typical annual household consumption levels of 18,000kWh for gas and 3,300kWh for electricity, the resulting annual household supply cost should provide food for thought in the rest of the EU.
Just before full market opening, in 2001, the supply cost for household gas was £30 per customer per year. In 2002 it jumped to £56, in 2003, 2004 and 2005 it was respectively £49, £68 and £55, before dropping precipitously to £16 in 2006. The same cost for electricity was £62 in 2001, £57 in 2002, £62 in 2003, £62 in 2004, £58 in 2005 and £88 in 2006.
These supply cost movements tell us three things. First, as should be anticipated, liberalisation increases aggregate supply costs for domestic customers (increased marketing costs, duplicated billing infrastructure, switching costs etc). Second, the level of these costs can be unrelated to the actual cost of supply as energy companies defend or increase their downstream profit margins. Third, while supply costs for gas and electricity should not be too different (the billing process is the same), in 2006 they were only £16 for gas, but jumped to £88 for electricity - providing a clear indication that a squeeze on gas supply margins brought about by the rising wholesale cost of UK gas was compensated for at the expense of electricity customers.
Full liberalisation in electricity and gas has either not got off the ground or has died a death elsewhere in the world. Through its impact on wholesale pricing and on supply costs and margins it is likely to result in both higher and more arbitrary prices, as well as making a lottery of investment incentives. But the European Commission presses on regardless at the expense of addressing more urgent energy problems. Somewhat ironically, its efforts are mainly sustained by the UK.
* British Gas data are used because the company is exemplary in disclosing the required information
The writer is professor of energy policy and economics at the University of Sheffield's Management School
What is liberalisation of the European Union's gas and electricity markets about? This question is worth asking because the European Commission has been preoccupied with how liberalisation needs to be introduced, rather than with its purpose.
Last month, this preoccupation reached fever pitch as a long-awaited package of proposals was adopted by the Commission, including a requirement that the EU's big energy companies should unbundle their gas and electricity networks from their supply businesses, either by establishing fully independent system operators or by way of complete ownership separation.
But what is liberalisation expected to achieve? A more competitive and transparent market and thereby lower prices is the stock reply. A possible relationship between liberalised markets and security of supply has been a more recent emphasis.
Such aspirations could be dismissed on the grounds that the gas and electricity industries are inherently unsuitable industries for competition. Here, though, I would like to challenge them by drawing attention to the impact of liberalisation on the three main cost components that make up the prices paid by households, which, since July, have seen their right to switch supplier extended throughout the EU.
These costs are the wholesale cost of gas and electricity, the cost of transmission and distribution and the cost of supply (billing and marketing).
The impact of liberalisation on wholesale costs is problematic in that short-term markets increasingly price electricity or gas delivered under long-term contracts. Such indexation to short-term markets (for example to month-ahead or day-ahead prices) is wrongly seen as a virtuous indicator of liberalisation, when in fact these markets establish a volatile flexibility premium as buyers and sellers seek to balance their positions when delivery day approaches and options increasingly diminish.
To counterpose them with "old-fashioned" long-term contracts and allow them to set a price for baseload supplies contracted for perhaps years in advance of a delivery day is therefore misplaced - such long-term supplies are more appropriately indexed to a wider basket of commodities, including alternative fuels, in order to reflect the different risk profile they offer. This is not a trivial matter: gas indexation has ruined otherwise viable businesses in the UK and made long-term investment decisions hazardous. The cost of transmission and distribution can account for as much as 30 per cent of prices to domestic customers. However, these costs are not directly affected by liberalisation: they are regulated costs.
This leaves the impact of liberalisation on domestic supply costs - which is a specific consequence of retail competition.
It can be observed with some precision using UK data. Coupling British Gas's supply cost data* with what the UK's Department for Business, Enterprise and Regulatory Reform tells us are typical annual household consumption levels of 18,000kWh for gas and 3,300kWh for electricity, the resulting annual household supply cost should provide food for thought in the rest of the EU.
Just before full market opening, in 2001, the supply cost for household gas was £30 per customer per year. In 2002 it jumped to £56, in 2003, 2004 and 2005 it was respectively £49, £68 and £55, before dropping precipitously to £16 in 2006. The same cost for electricity was £62 in 2001, £57 in 2002, £62 in 2003, £62 in 2004, £58 in 2005 and £88 in 2006.
These supply cost movements tell us three things. First, as should be anticipated, liberalisation increases aggregate supply costs for domestic customers (increased marketing costs, duplicated billing infrastructure, switching costs etc). Second, the level of these costs can be unrelated to the actual cost of supply as energy companies defend or increase their downstream profit margins. Third, while supply costs for gas and electricity should not be too different (the billing process is the same), in 2006 they were only £16 for gas, but jumped to £88 for electricity - providing a clear indication that a squeeze on gas supply margins brought about by the rising wholesale cost of UK gas was compensated for at the expense of electricity customers.
Full liberalisation in electricity and gas has either not got off the ground or has died a death elsewhere in the world. Through its impact on wholesale pricing and on supply costs and margins it is likely to result in both higher and more arbitrary prices, as well as making a lottery of investment incentives. But the European Commission presses on regardless at the expense of addressing more urgent energy problems. Somewhat ironically, its efforts are mainly sustained by the UK.
* British Gas data are used because the company is exemplary in disclosing the required information
The writer is professor of energy policy and economics at the University of Sheffield's Management School