COLUMN-UK utilities unmoved by threat of competition review: Kemp

Reuters - UK Focus

(John Kemp is a Reuters market analyst. The views expressed arehis own)

By John Kemp

LONDON, March 28 (Reuters) - Britain's major gas andelectricity suppliers shrugged off the threat of a marketinvestigation by competition regulators as investors concludedit is unlikely to recommend changes that could significantlyaffect their profitability.

Of the country's Big Six gas and electricity suppliers, onlyCentrica (LSE: CNA.L - news) and Scottish and Southern Energy aredirectly quoted on the stock market.

Centrica's share price closed up marginally, though itsshares have been hit hard since speculation about futureregulatory reforms began in September 2013.

SSE (LSE: SSE.L - news) 's shares fell 2 percent but the company is still tradingclose to its highest levels for the last decade.

The other four big retailers are part of large diversifiedgroups so the impact of Thursday's report from the Office of Gasand Electricity Markets (Ofgem) on their share prices cannot beobserved directly.

But if the proposal to refer gas and electricity suppliersfor a full-scale competition review was meant to signal arevolution in the country's energy business it seems to haveleft investors unmoved.

The report's scathing tone may have taken some in theindustry by surprise, however the decision to refer the gas andelectricity supply business for a competition review has beenwidely expected.

Some within the industry have actually been calling for acompetition reference in the hope it would take the issue out ofthe political arena and enable it to be settled once and for allby a thorough and technocratic process.

The bottom line is that it is not clear whether thecompetition review will or could recommend changes that wouldsignificantly alter the returns available to investors in thecountry's gas and electricity businesses.

For all its damning language, Ofgem's report struggles toexplain exactly what the problem is that a competitioninvestigation is meant to solve.

FLAWED MARKET

There are plenty of flaws in Britain's energy markets.

Customers have been deliberately confused by a bewilderingarray of complicated tariffs.

Former regional monopolies remain dominant in their oldareas and continue to charge higher prices to their legacycustomers.

Few customers switch supplier so the threat poses littlereal constraint on the prices gas and electricity supplierscharge. The number of customers who say they do not trust theirenergy supplier hit a record 43 percent in 2013.

Retail prices tend to rise quickly when wholesale prices goup, but fall slowly when wholesale costs go down. Priceincreases tend to be synchronised and Ofgem says there may be"tacit coordination" among the major firms although it has nohard evidence.

Entry barriers remain formidable. Centrica, the country'sformer gas monopoly, still has a gas market share of more than40 percent. The former regional electricity monopolies have anaverage market share of 37 percent in their home areas. Smallindependent suppliers have grown rapidly in recent years buttheir total share of the market is still just 5 percent.

In electricity, vertical integration between generation andretail distribution has left small independent suppliers at adisadvantage and led to suspicions that the Big Six are hidingtheir true level of profitability by shifting profits fromdistribution into the less transparent generation business bymanipulating transfer pricing.

Ofgem lays out all these concerns in convincing detail inits report.

But the real political problem is that prices have risenmuch faster than inflation over the past decade, squeezinghousehold budgets at a time when incomes have stagnated owing tothe financial crisis and recession.

RISING PRICES

The causes of price increases are not hard to find.

Wholesale gas prices have risen sharply. The country'sageing and carbon-emitting coal-fired power stations must bereplaced with cleaner gas-fired power plants and wind farms tocomply with EU directives and the government's own climatechange targets, which is expensive.

Most of the country's nuclear generating capacity wasdesigned and built in the 1960s and 1970s and is rapidly nearingthe end of its service life and must be renewed or replaced. Thebulk of the transmission network is even older, dating from the1950s and 1960s, and needs a major overhaul.

To reduce carbon emissions and encourage generation fromnuclear, wind and solar in future, governments from allpolitical parties have provided a range of generous subsidyprogrammes, all of which are being charged to utility customersthrough their bills.

On the demand side, Britain's housing stock is mostly old,poorly built and thermally inefficient. Government programmes toimprove weatherisation and energy efficiency are being paid forby levying additional charges on utility bills rather thanthrough general taxation.

For all these reasons, there is no question energy billswould have risen significantly since the turn of the century.

In real terms, household energy bills are still below thelevel in the 1970s and 1980s. In retrospect it is the lowutility bills in the 1990s that look like the anomaly ratherthan the high bills of the 2000s.

But the combination of rapidly increasing bills, economicstagnation and falling real wages since 2008 has proved apoisonous cocktail.

The real question for politicians, regulators and customersis whether the Big Six have made the rise in bills worse byexploiting their dominant position in gas and the generation anddistribution of electricity.

On this point, Ofgem's report is least convincing. Ofgempoints to lots of flaws in the way that the market is workingbut is unable to show any evidence that they have allowed theBig Six to inflate prices and profits.

THIRD REVIEW

All the matters which Ofgem is now proposing to refer to thenew Competition and Markets Authority (CMA) have already beenconsidered by the regulator before in its own 2008 Energy SupplyProbe and 2010 Retail Market Review.

The sceptical observer might wonder whether yet anotherreview will uncover any more evidence that has not already beenunearthed by the two previous inquiries.

Many of the problems, such as the bewildering array oftariffs, have already been addressed by reforms arising out ofthe earlier probes. But the fundamental question of excessprofits remains unanswered and undefined.

Overall profits earned by the Big Six from their retail andgeneration businesses have risen moderately since 2009.

But while profits earned from supplying residentialcustomers have risen more than four-fold, profits from thenon-residential supply business and generation have shrunk.

There is an enormous amount of variability among the Big Sixin where they earn their profits (gas versus electricity, retailversus generation).

It is therefore far from clear that anyone is earning asignificant amount of excess profit.

One persistent concern is that vertical integration hasallowed retailers to hide excess profits in their unregulatedgeneration businesses, as well as making it hard for independentretailers to acquire the wholesale gas and electricity suppliesneeded to enter the market.

Some commentators have suggested the Big Six should bebroken up and that no firm should be allowed to operate in bothgeneration and retail. But it is not clear if this would lowerprices for consumers.

Britain currently needs more generation capacity. For allcommentators claim generators are making excess profits, thegovernment is struggling to encourage new investment ingeneration capacity at the moment.

In future, the government will probably have to givegenerators more incentives, not fewer, to build and run newcapacity in a bid to ensure the lights remain on.

Small independent suppliers claim they are much cheaper thanthe Big Six. But most are able to cherry pick their customersand mostly serve affluent and informed households.

Small suppliers do not have the same environmental andsocial obligations as the Big Six (including supplyingsubsidised energy to vulnerable low-income, disabled and elderlycustomers, dealing with customers with poor credit histories,and insulating old homes).

So it is not clear small independent suppliers could delivergas and electricity to the average household much more cheaplythan the Big Six do at present. (Editing by Keiron Henderson)

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