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To What Extent Does Market Liberalisation Influence Competition In Gas And Electricity Sector

| February 8, 2017

ABSTRACT

Market liberalization is a modern concept adopted by many governments around the world. It has gained fame due to its ability to enhance efficiency and quality due to competition. This paper presented an analysis of the liberalization of gas and oil sectors in the United Kingdom. The analysis was limited to the level and effects of downstream liberalization of these sectors.

The approach adopted by this paper included review of several sources that relate the various changes that have taken place in the UK electricity and Gas sector since 1980s. From the analysis of the concept of liberalisation and its application in the gas and electricity sectors in the UK, it is evident that it is directly linked to the introduction of competition. Liberalisation in these sectors involved unbundling of downstream infrastructure and activities, opening up the sectors for competition. The fact that UK produces most of its electricity and gas makes it to have full control of its downstream liberalisation. UK has effectively managed to introduce and maintain downstream competition enhancing the impact of liberalisation in the sectors. In addition, the separation of the activities of the sectors promotes free competition in the downward segment of the two industries as the government is in a position to offer independent regulatory framework that promotes liberalisation in the sectors.

INTRODUCTION

Market liberalisation has been a major policy in most developed economies in regard to electricity and gas sectors[1]. The push of introducing competition through privatisation in the gas and electricity sectors emerged in the 1980s with the United Kingdom and the United States pioneering liberalisation in these sectors with a success[2]. The adoption of liberalisation in the gas and electricity sectors has resulted to shift from state owned vertically integrated monopolies to privately owned, liberalised market participants that operate under government regulations are well as environmentally conscious environment[3]. Consequently, the traditional approach to doing business in the gas and electricity sectors has been changed as the industries move from large dependence on the capacity to reliance on short-term market price signals, flexible energy policies and tentative environmental regulations[4].

Therefore, the ultimate approach adopted in introducing downstream liberalisation in the oil and gas sectors was through the introduction of various reforms by the government that initiated a shift from government owned monopolies to a competitive formation[5]. As much as the eventual benefit of downstream liberalisation is increased efficiency and competitiveness that results to lower prices for commodities in the market, government regulations play a central role in regulating operations of these sectors[6]. This paper will focus on analysing downstream liberalisation in the gas and electricity sectors in UK and how it promotes competition

BACKGROUND INFORMATION ON ELECTRICITY AND GAS SECTORS IN THE UK

The underlying principles for reforms in this sector was that privatisation of the sectors would provide better competition than direct state ownership[7]. The analysis of the two sectors was conducted independently for development of deeper insights of the level liberalisation as well as future prospects in terms of downstream competition.

The Gas Sector

UK is the third largest consumer of gas in the world. Its use of gas is not limited to a source of energy as its use as a fuel in electricity generation is on the increase as the use of coal is being dropped due to its heavy carbon footprint. Most of the gas used in the UK is sourced from its offshore gas fields; however, this is bound to change in the future as its deposits are diminishing[8]. The offshore production process in UK is very competitive with numerous fields exhibiting diffuse ownership.[9] Onshore pipeline operations are dominated by Transco as much as there are 11 other independent pipeline operators in the UK[10]. Downstream competitiveness is also boosted by over 100 wholesale gas outlets who mainly deal with gas shipment.

Compared to other countries in Europe, competition in UK’s gas sector is very steep due to the boundless extraction potential in its offshore sources,[11] enhancing downstream competition. Before liberalisation of the gas sector in UK, wholesale gas contracts were restricted take-or-pay commitments, long-term and linked to international oil prices. The emergence of liberalisation in the 1990s resulted to competition with an upsurge of players[12]. This automatically resulted to reduced contract periods, take-or-pay commitments were lessened, and the price of gas is no longer linked to the oil prices. Furthermore, the UK has implemented measures that promote relationships between gas transports as a service and gas supply as energy has enhanced the level of stratification of the gas sector as more wholesalers enter into the business[13]. Subsequently, the process of production of gas and transportation of gas in the UK are separated and operated by different companies.

The UK gas pipeline system is connected to the mainland Europe which functions in two ways. Most of the connection is used for gas export purposes to other European countries while during winter the pipeline is used for importation to bridge the demand gap as production is slowed down during those times[14]. The large size of Europe market relative to UK results to price arbitrage between UK and Europe, which in most cases increases the wholesale prices of gas in UK. The effect of low level of downstream liberalisation in the European gas sector makes the shift in gas prices in UK insignificant due to poor levels of downstream competition in Europe[15].

The 1972 Gas Act resulted to the merger of the coal gas supply industry to a government owned monopoly. This monopoly was reinforced by the fact that the government owned all onshore gas infrastructures. The liberalisation program was introduced in 1980s by formulation of the Oil and Gas Act of 1982 that aimed to introduce competition in the sectors[16]. This act passively promoted competition through the development of a better framework for awarding contracts[17]. The 1986 Gas Act initiated privatization of government owned BG Company as an effort of cultivating liberalisation and competition in the gas sector. However, real competition in the gas sector in UK emerged in 1990s. This was boosted by the Gas Act of 1995 that promoted unbiased competition in the gas market where production process and transportation process were separated and price control for storage and transportation was split[18]. This was an important aspect that promoted an increase in the number of players in the field promoting competition.

The Electricity Sector

The process of liberalisation of the electricity sector in UK was initiated in 1990[19]. This was initiated by splitting of the government owned Electricity Company into four companies[20]. Three companies were involved in generation while one was involved in transmission of electricity in UK. The two non-nuclear companies were privatised by 1991while the nuclear company remained a public company. The supply system was transferred to 12 regional private companies[21]. The main aspect of this shift of ownership from government to private in the electricity sector was the horizontal downstream severance, which resulted to competition. To enhance downstream competition, the pool system was introduced with the aim of centralizing trade in the electricity as well as develops a balance between demand and supply[22]. The pool system is a single price system that is defined by the bids offered by the generators. The government also introduced regulated reintegration of the electricity production and supply sectors as an approach to promoting efficiency. In 2001, the pool system was abandoned in favour of the wholesale market framework based on New Electricity Trading Agreements (NETA) that promoted integration of gas and electricity sectors as gas became a major fuel for electricity generation in the UK[23].

The introduction of NETA as the main regulatory system in the electricity sector enabled the development of effective linkages between the regulated monopoly of balancing and the competitive market.  This system promoted segregated downstream ownership, which has reduced the number of regulations needed to guarantee non-biased access to the networks. Downstream competition is no longer managed by price regulations. Quality has become the main threshold of downstream regulations resulting to intensification of quality controlled competition[24]. There are numerous reasons that affect the process of liberalisation in this segment

Firstly, the changes in the UK electricity sector were based on reforms that aim to develop competition through privatization[25]. The argument was that a pro-competitive industry is better that one that is devised based in regulations in managing maker powers. The privatization of electricity generation required numerous regulations, which require a long period of time to completely eliminate all the anti-competitive forces in the sector. Secondly, the use of regulations is slowly defining activities that promote completion in a sector that had a high level of monopoly. The competition problem in this sector emerge due to various activities require application of natural monopoly. These challenges are handled by sustained changes in the regulatory framework to promote complete downstream liberalisation in the electricity sector[26].

The strong vertical relationship in the electricity sector also results to complications where downstream competition problems affect upstream competition[27]. For instance, capacity problems at one production unit may require other production system to alter their production to compensate the deficit. Likewise, vertical competition is easy to distort due to availability of various avenues that may promote distortion of competition. This is common where the returns of the market are regulated below the monopoly price. As a result, competitive activities by former monopolies results to various challenges with regard to regulations[28].

The main successes realised in the reforms of the electricity sector in the UK is the implementation of the Ofgem proposal[29]. This proposal has resulted to extension of NETA by introducing tradable electricity, financial firm, and development of market based electricity production system. Generally, the electricity reforms taking place currently aims to completely eradicate regulation systems such that the downstream liberalisation in the electricity sector is fully realised to promote full-scale competition, where the operations of the sectors are fully controlled by the market forces[30].

DESCRIPTION OF ELECTRICITY AND GAS SECTORS IN THE UK

From the above preview of what is happening in the electricity and gas sectors in the UK, it is evident that the sectors are moving towards the realization of complete liberalisation as regulations loosen. The development of regulations was initiated with a focus on price regulation but as time went by, they are mainly focussed on quality control. These changes have raised some issues that require detailed analysis to develop a comprehensive presentation of how downstream liberalisation in these sectors promotes competition.

Downstream Gas sector

This is majorly driven by the 1995 act provisions that define the activities of downstream gas sector and how competition is achieved. To be able to analyse the process of downstream competitiveness, it is necessary analyse the elements of the code as it determines how downstream competition in the gas sector is achieved. The first aspect of the code is that the shippers book supply to the national transmission system for a 12-month period where the price of supply are determined by location of injection point[31]. Gas is bought and sold by Transco based on flexibility mechanism to ensure no shortfalls are experienced as a result of shippers’ imbalances[32]. Transco is also responsible of ensuring the available inventory sustains peak seasons such as during winter[33].

Analysis of the offshore gas mining fields reveals intense liberalisation strategies that promoted competition. Specifically, the North Sea gas fields in UK are managed by 25 different operators that share 129 gas exploration licences[34]. The introduction of various players in the production process automatically eliminated monopoly, which has been a major problem in downstream gas liberalisation. However, government still regulates the production process of gas resulting to partial liberalisation in the production system[35].

Downstream oligopoly in the gas sector

The fact that gas supply is limited to a few locations that are mostly offshore and some imported from a few countries that are globally known for their huge amounts of gas reserves, there are very few players in the production and supply of gas in the UK. The ability of UK to produce its gas locally makes its supply chain manageable and directed to full liberalisation covering both upstream and downstream[36]. Oligopoly as a market structure in the gas sectors has been in existence in the UK since 1970s with its upstream market. The perception of oligopoly in the UK gas sector is founded on the fact that a market that is exposed to perfect competition has players that have fewer concerns about the operations of their counterparts. An action by one players results to a reaction by the other. For instance, if one firm is unable to meet its production requirements, another company increases its supplies to ensure the gap left by the other firm is levelled. Similar case is evident in product pricing where all the companies develop almost similar pricing partly regulated by regional needs within the UK[37].

Therefore, UK gas supply system is operated based on oligopoly of its 25 main supplies from the offshore gas fields where the final price of the gas is determined by the effects of informal collision between the suppliers. The collision price of gas in UK is also affected by the global oil price that is normally used as a reference point in most cases. The fact that currently there is no excessive dominance in the downstream segment as most government operations have been privatized; the prices charged by the wholesale suppliers is similar.

Implications of liberalisation in UK’s Gas Sector

Before the concept of liberalisation was introduced in the gas sector in the UK, there was a high level of monopoly in the gas production system with the government owning almost all offshore gas fields in the UK[38]. Liberalisation has resulted to entry of new players with government monopoly being eliminated and competition taking its roots. However, downstream gas sector in the UK is not fully liberalised as in the case of upstream due to high levels of government regulations in an effort of ensuring supplies meet the demands and prices are regulated within acceptable standards. Furthermore, the high costs of investments needed in downstream segment of UK’s gas sector limit entry of new players resulting oligopoly as the main approach to downstream competition in the gas sector. Therefore, downstream liberalisation in the gas sector has opened it up to competition through processes that resulted to separation of the production chain from supply chain, introduction of competition through privatization of government monopolies, and development of regulatory frameworks that control areas that are still affected by natural monopoly[39].

Downstream Electricity Sector

The production of electricity in the UK has undergone numerous changes since early 1990s when coal and nuclear dominated the generation system. New plants that operate using gas and nuclear have been installed while several coal and oil based plants have been shut down as the country embraces the spirit of green energy. The concept of liberalisation is also evident in the system as most of the new generation systems developed from the 1990s are privately owned[40]. The introduction of private companies in the power generation automatically resulted to the decline of dominance in the sector by national power and power gen which are state owned companies. This is evident as government dominance in power generation is lowest in the UK as compared to the rest of Europe. The success of UK electricity sector is founded in its effective regulatory framework that has protected it from the faults that were evident in California and Australia when downstream liberalisation was introduced[41]. The regulatory system adopted in downstream electricity sector in the UK is market based. Moreover, the UK downstream electricity sector is devised based on strong market incentives that promote entry of new players as a way of fostering competition[42]. NETA has successfully managed to keep the wholesale electricity prices low making it possible for new players to enter into the production system and compete favourably. The fact that the transmission system is still monopolised, downstream liberalisation is limited to production as much as the government has set various measures to ensure it does not interfere with downstream and upstream liberalisation[43].

The government has initiated various regulatory changes that promote competition between market players. The main aspect that promotes completion is the market share that is defined by a company’s effectiveness and competitiveness. The most important aspect of liberalisation in the electricity production system is to introduce competition as the main aspect of promoting innovativeness and efficiency among the players in the sector[44]. The success of UK system is founded in its approach that promoted competition amid independent producers and existing government firms.

Competition as a result of liberalisation of the UK’s electricity downstream sector was promoted by development of regulation of monopolies in the sector with the aim of eliminating the traditional vertical integrated system. Liberalisation broke down the structure into three sections, which were downstream, transmission, and upstream where competitive markets replace the vertically integrated firms with government monitoring and regulation. The approach to liberalisation in the UK’s electricity sector was based on transmission system operators (TSOs)[45]. This system is based on the concept that ownership and transmission planning are integrated components of the market and system operation[46]. The state ownership of the transmission system is central to the success of the system as it ensure unbiased treatment of the firms involved in the downstream production of electricity. More so, the use of TSOs has enhanced coordination between the electricity producers enhancing competitiveness as information exchange is encouraged[47].

The electricity market is complex due to inability of the producers to store the produced power in large quantities and the existence of varied demand conditions. The need of electricity production system to meet the demand needs and flexibility makes the process of downstream liberalisation to be regulated to ensure system stability[48]. The lack of constant consumption pattern in electricity results to price volatility in the wholesale electricity market. These complexities tend to play down on competition as reliable supplies are used during peak seasons resulting to instances of oligopoly in the downstream electricity sector.

Generally, there are some complexities in downstream electricity sector in UK; however, the introduction of liberalisation that has been subjected to continuous improvement to ensure liberalisation is fully realised has created competition as evident in the introduction of the pull system that resulted to competition lowering prices[49]. NETA is another major body that not only enhanced competition in the electricity sector but also resulted to further drop of prices as players increased promoting price competitiveness[50]. The recent vertical reintegration in the UK electricity sector where large electricity producing companies are acquiring retail distribution businesses this is another factor that will further enhance competitiveness in the sector as players develop links that offer them direct access to the final consumer of their product[51].

CONCLUSION

The analysis of the concept of liberalisation and its application in the gas and electricity sectors in the UK reveals its direct link to the introduction of competition due to the introduction of many players in the downstream segment and the eventual opening up of the segments to market forces that are ineffective to monopolistic market structure[52].

The paper examined a historical account of the regulatory changes in the process of liberalizing the UK gas and electricity sectors providing links between liberal policies and regulations and opening up of the sectors to competition. The most evident aspect of liberalisation that promoted competition was the privatization of government monopolies in the production of electricity and gas in the country. Specifically, it was evident that the process of liberalisation of gas and electricity sectors is affected by the types of commodities that are handled by the players in the two industries. Furthermore, the fact that UK produces most of its gas and electricity locally makes it an interesting participant in downstream liberalisation. However, the uniqueness of the properties of electricity and gas require infrastructural systems that are managed by the government to ensure a level playing field for the downstream segments in the gas and electricity industries in the UK.

References

Primary sources

International Decisions

OECD. 2005. The Benefits of Liberalising Product Markets and Reducing Barriers to International Trade and Investment: the Case of the United States and the European Union. OECD Economics Department Working Paper 432, Paris

National Legislation

Great Britain. 2009. UK offshore oil and gas: first report of session 2008-09, Vol. 1: Report, together with formal minutes. London, UK: The Stationery Office

Great Britain. 2011. The UK’s energy supply: security or independence? eighth report of session 2010-12, Vol. 1: Report, together with formal minutes, oral and written evidence. London, UK: The Stationery Office

 

Secondary sources

Books

Armstrong, M., Cowan, S. & Vickers, J. 1994. Regulatory Reform, Economic Analysis and British Experience. Cambridge, MA: MIT Press

Geradin, D. 2001. The Liberalization of Electricity and Natural Gas in the European Union. South Holland: Kluwer Law International

Gao, A. M. 2010. Regulating Gas Liberalization: A Comparative Study on Unbundling and Open Access Regimes in the US, Europe, Japan, South Korea, and Taiwan. South Holland: Kluwer Law International

Parker, D., 2012. The Official History of Privatisation, Vol. 2.  London, UK: Routledge

Smith, M. P.  2012. States of Liberalization: Redefining the Public Sector in Integrated Europe. New York, NY: SUNY Press

Surrey, J. 2013. The British Electricity Experiment: Privatization: the Record, the Issues, the Lessons.  London, UK: Routledge

Articles

Joskow, P. & Tirole, J. 2000. Transmission rights and market power in electric power networks. Rand Journal of Economics, 31(3), 450-487

Newbery, D. 2005. Electricity Liberalisation in Britain. The Energy Journal, special issue on European Electricity Liberalisation.

Wolak, F. & Patrick, R. 2001. The Impact of Market Rules and Market Structure on the Price Determination Process in the England and Wales Electricity Market. NBER Working Paper 8248

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