Title : DOES THE UK ENERGY SUPPLY INDUSTRY POSSESS EXCESSIVE MARKET POWER AND DIOES IT ENGAGE IN ANTI-COMPETITIVE PRACTICES

? HOW CAN GOVERNMENT PROTECT THE CONSUMER, THE POOR AND THE AGED ? Introduction:

A mixed market economy contains both a command economy as well as a free market economy. This means that a private sector does exist with some power of allocation of resources and distribution of income, but there is also a degree of government intervention. The market structures that exist in this economy are perfect competition, monopolistic competition, oligopoly and monopoly.

A Perfectly competitive market consists of many buyers and sellers, where all the firms in the market are price takers and there is freedom to entry and exit. The market price is not affected much by a single seller or buyer, but is affected by changes in the industry as a whole. A monopolistically competitive market structure has many sellers and little barrier to entry. In this market each firm sells differentiated products and as a result of this each product has a negatively sloped demand curve. A monopoly consists of only one firm in the industry another word the firm itself is the industry, where there is no close substitute of goods. Plus barriers to entry prevent other firms from entering, therefore preventing competition. There are two sub-groups of monopolies, regulated and non-regulated. In a regulated monopoly, the government allows the firm to set prices to give them a fair amount of profit. In a non-regulated monopoly, the government plays no role and the firm sets its own prices. An oligopoly is where there are a few firms which dominate the market which results in each firm having high market power which allow them to be price makers rather than price takers. It also means there are high barriers to entry and exit in the market which therefore reduces competition. There are two types of oligopolies; collusive and non collusive. A Collusive oligopoly is like a cartel, where firms have an incentive to collaborate to determine price and output, collectively acting like a monopoly. There are 3 types of collusive behaviour open, closed and tacit; open is when the collusion has been taken and approved by the government as it in some way beneficial for the customer. Closed is when the firms are colluding behind the government, although this is hard to prove, if this is proved the firms would encounter a huge fine. Tacit is when firms follow the pricing strategy of the dominant firm; this is very difficult to prove. In essence this is abuse of market power as it is an anti- competitive practice and therefore it is illegal in the UK. But this sometimes fails when a firm has a tendency to cheat. However they can also choose to be non-collusive this means that they do not cooperate with each other and behave as competitors but this does not necessarily mean they are abusing their market power. The UKs energy industry is an example of an oligopoly as there are only a few firms in the industry which have a high concentration ratio meaning they are sensitive to each others prices, characteristics of an oligopoly.

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This kinked demand curve shows the average revenue curve in an oligopoly market and the equilibrium price is at E. If one firm is to raise their price, other firms do not follow and the profit gained will decrease, this is where the curve is elastic. When one firm reduces their price others will follow and the profit gained will increase by a small amount, this is where the graph is Inelastic.

The energy industry was previously state owned until 1990s (Appendix 10) when the beginning of privatisation began. The reason for this was to break down barriers to entry in the industry which would make the market more competitive. Which in turn boost market supply bringing down prices for consumers and encourage an increase in competition. The increase in competition would lead to investment flowing into the market for technical change which might contribute to an improvement in average standard of living. As a result of privatisation the assets of the CEGB was broken up into Powergen, National Power and National Grid Company. The Table 1.1: below shows market structure and control of the 6 top dominant firms in the energy industry. Suppliers E.ON: EDF: Ownership E.ON is the world's largest investor-owned power and gas company Based in Dusseldorf, Germany EDF energy is one of the UKs largest energy companies and its largest producer of low-carbon electricity. It is based in France. Npower parents company is German giant RWE which recently has been fined 1.5m by a Paris court for spying on Greenpeace. Controlled by Iberdola, a huge Spanish Utilities company Centrica ltd took over the British Gas name in the UK Based in Perth, Scotland since its inception in 1998

NPower:

Scottish Power: British Gas: Scottish and Southern energy:

The big six energy companies at the moment have huge market positions and this act as a reduction for competition, a reason why they have gained this is firstly due to high barriers to entry, new entrants such as OVO energy are not growing as quickly due to competitors like British gas. High branding by British gas causes reluctance of consumers to change energy supply due to brand loyalty. This makes it even more difficult for firms to enter the market as they have to advertise more causing their sunk costs (irrevocable costs) to increase. Another reason is the existence of Asymmetric information; this means that consumer knows less about the firms and what they are offering. There are 544 different available tariffs out there and Consumers are unaware of the right tariff and this causes a barrier. It also makes it harder for the consumers to compare and switch their suppliers which results in many consumers sticking to expensive tariffs which are not beneficial for them. According to BBC, 85% of consumers are not switching tariffs because too many tariffs have made it harder for the consumers to take in and fully understand the terms of the deal. This causes less incentive for new firms to enter the industry as its hard for them to gain potential consumers. (Appendix 2) High start-up costs can act as a natural barrier to entry, the fluctuating prices of oil and coal can deter new entrants as they may not have the capital to fund the raw materials this means that they are finically incapable causing a barrier for them to enter. Finally the existence Economies of scale can also acts as a natural barrier for new firms to enter; this allows firms to lower their long run average costs while increasing output. These companies have been operating on a downward sloping long run average cost curve due to increased investment in technology which has lowered the cost of production. However, in the short term when only one factor of production in variable and others constant, it may be that the initial investment cost is high. If the firm try and optimise their inputs by changing one factor of production and keep all others constant. This essentially lowers their cost as they become more efficient, also known as diminishing return, which is an essential part of the Production theory.

The graph below is the long run production theory which shows the long run average cost declining as economies of scale is achieved.

Firm created barriers can also exist as predatory pricing, and mergers. Biggest supplier of energy was British Gas and smaller firms found it difficult to compete with this firm and therefore began to merge which increased the size of their market share which results in a reduce in competition. As economies of scale maintains market power for energy firms which indicates that the industry is very concentrated because lower average cost lead to high supernormal profits especially in market where demand is Inelastic, this means that a change in price have a less than proportionate change in quantity demanded. Concentration is a measure of the number of firms which dominate in an industry. A high concentration means there are a few firms in the industry, these are usually oligopolies. The electricity industry has a five firm concentration ratio of 55% (Appendix 8) and gas industry has a five firm concentration ratio of 82% (Appendix 9). This means that the top five firms accounts for 55% of all the sales in the electricity industry and accounts for 82% of the sales in the gas industry. This clearly indicates that the energy industries are achieving supernormal profits by using their market power. A high concentration could lead to collusion in the electricity industry. Collusion is when firms co-ordinate with each other and act as a monopoly so they can set higher prices benefiting them by increasing their profits, but not consumers because they will have to pay a higher price. Also since energy is a necessity, consumers will pay the higher prices. Economists believe that the Market power leads to dominance and this reduces competition but economists believe that competition is better (diagram) as prices would be lower than a monopolistic firm. On the 17th October 2011 the British prime minister said, We are making energy companies be competitive. Theyre permanently being watched by OFGEM to make sure it is a competitive market, and we are making them make their energy available so that others can come in and provide consumers with a good service. Were also writing to millions of consumers today to encourage them to shop around to get the cheapest possible deal they can for their energy. So this is about the Government, about the Citizens Advice Bureau, about other organisations, all working together to help people to keep their energy bills down. From this the British prime minister made clear that people have imperfect market knowledge and there should be more help from the government and other sources to make aware of different tariffs and services provided by the energy companies.

The energy industry has not yet been caught in the practice of collusive behaviour, however they have been making profit margins as large at 9% although only aiming for 5% these profits are said to be invested for future energy supply for Britain in the next 10 years,(Appendix 2) and also may be used for research and development which could possibly lower the cost of production of these companies. (diagram excess profits), and therefore lower the prices of energy but instead these prices have been rising overtime, reportedly increased by 21% or (already paying 10% plus an extra 20% has been added to the energy bills) as you can see from the diagram below the retail price trend is increasing more rapidly than the wholesale price which questions whether they are abusing their market power.

Appendix 5

On the other hand it may not necessarily mean they are abusing market power because they may want to pursue other objective such as revenue and sale volume maximisation or to invest in research and development so they can be more innovative on energy production and efficiency. Furthermore the might also not abuse the market power because of the fear of regulating bodies such as OFGEM (office of gas and electricity markets) fining them. Additionally they will be reluctant to abuse their market power which could lead to potential interest from outsiders to enter the market in order to catch supernormal profit.

Appendix 3

We can see from the test done by OFGEM that a rise in whole sale price of 12 leads to a rise of 13 in customer bill however a decrease of 13 in wholesale cost only leads to a decrease in 5 in consumers bills. This is a clear evidence of abuse of market power by dominant firms where there are responding faster to rising cost than falling costs. Firms are charging higher prices even when their wholesale costs are low. Since we know electricity and gas are inelastic as it is a necessity, the big six firms acting as monopoly, are taking advantage of consumers by charging them high prices because they have no access to substitutes.

The government may choose to intervene in the price mechanism largely on the grounds of wanting to change the allocation of resources and achieve what they perceive to be an improvement in economic and social welfare. This is done to achieve a more equitable distribution of income and wealth or to improve the performance of the economy, promote competition and most importantly to ensure that economy as a whole avoids inflation and recession. The government may intervene to make sure the industry is well competitive and firms are competing with each other to offer cheap price for consumers rather than getting involved in anticompetitive behaviour and set a high price as a monopoly and make supernormal profits. Governments can also intervene in market economies when there is market failure, this is where a market fails to satisfy the consumer with their needs or wants. Market failure can be caused by many factors such as; externalities, imperfect market knowledge and a factor most relating to this essay is substantial market power in the hands of the energy producers. Externalities are the third party costs due to a production of a good or service, essentially the third party effects ignored by the price mechanism. These cause the market to fail if the external costs are not accounted for. The private costs to a firm are the costs for the firm to produce, so the cost of land, labour, raw materials, capital and so on. But external costs can include pollution, so the waste due from production which, if not accounted for, can have affects on others (third party). An example of this is pollution from the production of energy. Firms would have to pay the cost of polluting on top of their other input cost. Imperfect market knowledge is when consumers and producers have imperfect and unequal knowledge of the market. This is known as asymmetric information which was discussed earlier. The market fails when producers who have substantial market power, abuse their power and choose to satisfy themselves rather than satisfy the consumers. One example that relates to this essay is the pricing of electricity as shown before; electricity doesnt have to be as expensive as it is, yet the firms supplying set these prices for their own interests. Since we know from the argument above that UK energy firms are abusing their market power by charging higher prices even though their price of inputs are lower, the government may intervene to give consumers fair price to pay for the utilities and to prevent the big firms who are acting like monopoly from abusing their market powers and charging high prices and making supernormal profit. IF the government recognizes that the energy firms are charging too high prices then the government along with OFGEM could introduce price capping. This can be done by putting price ceiling and price floor. The government can limit the maximum price charged by keeping a price which is below the market price otherwise it will have no effect since consumers are already ready to pay the market price. OFGEM could also adapt ways of dealing with the abuse of economic position such as liming the market shares, to tackle unfair energy bills. OFGEM said the big six firms should face more competition by forcing the energy firms to give up a certain percentage of electricity they generate and that way make rooms for new companies to enter the market. More suppliers would mean a surplus in the market which would lead to a decrease in price and every firm will make normal profits. (Appendix 4) Reworded This would also mean that competition between the firms in the market would motivate firms to invest their supernormal profits in research and development and in technological change to become more efficient. For instance, Centrica Plc (trading as British Gas/Scottish gas) only owns 20% of the nuclear power generators (rest owned by EDF). Centrica the biggest UK energy generator could invest its excess profit of 1.3 Billion as reported by OFGEM in more offshore wind farms which could reduce the problem of negative externalities.

However rather than having a direct conflict with the firms the government can try to make the market more competitive by helping to cover the entry cost for new firms. For a new firm to enter this market it must have good financial ability to cover its starts up cost. Therefore the government can reduce barriers to entry by providing financial subsidies (grant) to firm to meet new start-up cost and be financially healthy to compete with big firms, which would eventually bring the price down making the market perfectly competitive and as we know from the theory too many firms would mean more supply which would then lead to prices going down and each firm will make normal profits. This would enable consumers to pay normal price for the use of energy. (Appendix 6)

Furthermore the government intervene to help the consumers directly who are on low income or aged by introducing Schemes which could help to reduce people energy bills. The three main schemes provided by the government are the following: Home energy saving programme which is mainly aimed to help people with low income as well as pensioners to help to make their home more energy efficient. Warm front England is specifically aimed to help privately owned or rented home. This service provides wall insulation or loft insulation which could make homes more energy efficient. Winter fuel payment is aimed to help the aged by providing a grant which could help them pay their energy bills during the winter when the use the energy is usually increased.

In addition OFGEM has proposed the major energy suppliers to simplify their tariffs so consumers will have a better idea of the deals offered by the energy suppliers and therefore being able to compare and switch to the cheapest provider available. (Appendix 7)

Conclusion: To conclude we believe that the UK energy industry does possess excessive market power while also engaging in anticompetitive practices. All major suppliers have raised their energy prices dramatically lately and they all seem to blame the whole sale cost for these increases. The question is really why the energy bill has not reduced during the period where the whole cost were reduced. This was first reflected as the abuse of market power and collusive activities by the major energy providers. Even though OFGEM has confirmed after 7 month investigation that they were unable to find any evidence of the big firm being colluded (Appendix 11), we believe that the energy suppliers are being unfair to their consumers as you have seen from figure 2, where a decrease of 13 in wholesale cost only leads to a decrease in 5 in consumers bills. Furthermore we believe that increasing the number of tariffs is a strategy by the energy providers to deliberately make it harder for the consumers to find the cheapest deal available.

The question now lies on how much will we have to pay in 2020, government forecasts say on average 1239, the citi investment and analysis say 2000, and Uswitch has reported 3202, Compared to the 1345 per household being paid every year currently. DOES THE UK ENERGY SUPPLY INDUSTRY POSSESS EXCESSIVE MARKET POWER AND DIOES IT ENGAGE IN ANTICOMPETITIVE PRACTICES ? HOW CAN GOVERNMENT PROTECT THE CONSUMER, THE POOR AND THE AGED ?

Appendices: 1 2 3 4 5

Source: BBC news

http://www.ofgem.gov.uk/Pages/MoreInformation.aspx?docid=7&refer=Markets/RetMkts/rmr http://www.bbc.co.uk/news/business-12802591 YouTube video

6 7 8 9 10 11

http://ec.europa.eu/competition/sectors/energy/electricity/electricity_en.html http://www.bbc.co.uk/news/business-1174251
Economics Lipsey and Chrystal http://en.wikipedia.org/wiki/Concentration_ratio http://en.wikipedia.org/wiki/Timeline_of_the_UK_electricity_supply_industry (http://www.telegraph.co.uk/finance/newsbysector/energy/2782758/Ofgem-backs-firms-over-price-fixing.html)

Price discrimination is where a frim charges two different prices for the same good to different groups of consumers. Characteristics of price discrimination involve differing price elasticitys of demand in markets, no arbitrage (resale), and the firm must hold high market power. The energy industry are said to be practicing price discrimination, between existing consumer and potential new consumers. They can do this because they hold a substantial amount of market power and energy cannot be resold. The existing consumers are being charged higher than the new consumers, this is to attract the new consumer. This causes a barrier to entry as new firms may not be able to compete with the price of the tariffs charged to these consumers, not only that existing consumers are not switching due to asymmetric information. The graph below shows the profit obtained by the consumers.

Graph (A) is the existing consumers, this market is making the most profit due to the graph being inelastic, and graph (B) is for new consumers, this market is making less profit due to an elastic demand curve. The overall whole market represent the energy industry is showing the total profits the industry makes.