COMPETITION AUTHORITY DISCUSSION PAPER. No. 3

COMPETITION AUTHORITY DISCUSSION PAPER No. 3 Proposals for the Electricity Supply Industry in Ireland: Comments on the Consultation Paper published by the Department of Transport, Energy and Communications. Patrick Massey * November 1997. Price: 4.50 5.00 including postage * The author is Director of Competition Enforcement at the Competition Authority. Comments on the present paper should be addressed to the author. The author would like to acknowledge helpful comments made by Paddy McNutt, Bill Prasifka, Isolde Goggin, Una Brady, Patrick Kenny and Tony Shortall.

CONTENTS Page Chapter 1 Introduction and Summary. 3 Chapter 2 Basic Features of the Electricity Industry. 5 Chapter 3 EU Directive 96/92/EC on common rules for the 13 International market in Electricity. Chapter 4 Proposals made by the Department of Transport, 15 Energy and communications. Chapter 5 Market Structures and Competition. 19 Chapter 6 Institutional Aspects of Regulation. 32 Chapter 7 Conclusions 45 2

Chapter 1 Introduction and Summary. 1.1. In May 1997 the Department of Transport, Energy and Communication published a consultation paper outlining proposals for the future of the electricity supply industry in Ireland. The Department s paper was prepared with the assistance of National Economic Research Associates. The Department invited comments on the paper. The Authority submitted its views to the Department in July 1997 giving its views of the Department s proposals as set out in the consultation paper. The current paper is a slightly modified version of the Authority s submission to the Department of Transport, Energy and Communications. 1.2. The electricity industry plays a major role in the economy. Electricity is an input into virtually all types of economic activity. In addition it powers a wide range of household appliances. Thus any major changes in the industry will potentially have effects for every household and business in the State. 1.3. The adoption of EU Directive 96/92/EC on common rules for the internal market in electricity requires some reform of the electricity supply industry within the State. The Consultation Paper outlines the Department s proposals in this regard. The publication by the Department of a consultation paper on the electricity industry is a welcome step. The importance of the electricity industry to the economy as a whole means that proposals for the future of the industry merit a serious public debate. The Consultation Paper is, however, extremely brief and a number of key issues are not dealt with at any great length. Indeed a number of key issues are presented as having been already decided, thus greatly reducing the scope for comment and consultation. 1.4. The main conclusions of the current paper are as follows: The introduction of competition into the electricity sector is desirable as it is likely to benefit the economy as a whole. The question of vertical separation of the ESB which would involve establishing separate stand alone companies which would own and operate the transmission and distribution networks needs to be considered. Consideration should be given to limiting the amount of new generating capacity which could be built by the ESB as a means of promoting greater competition in generation. A more detailed analysis is required of the relative merits of Third Party Access and the Single Buyer models. 3

A specialised regulatory regime needs to be established to deal with questions such as access charges for use of the transmission and distribution networks and possibly to regulate output prices. This should operate alongside existing competition law. Questions of abuse of dominance other than output and access pricing issues should continue to be subject to general competition law and the Competition Authority should continue to be responsible for enforcement. 1.5. The current paper is structured as follows: Chapter 2 outlines some of the basic characteristics of the electricity industry in Ireland. Chapter 3 summarises the provisions of the EU Directive 96/92/EC. The main features of the proposals made by the Department of Transport, Energy and Communications are set out in Chapter 4. The question of competition in the electricity sector, including structural reform is considered in Chapter 5, while Chapter 6 looks at regulatory issues. Some conclusions are presented in Chapter 7. 4

Chapter 2 Basic Features of the Electricity Industry. Basic Economic Characteristics of the Electricity Industry. 2.1. The production and supply of electricity to final consumers is a highly complex, integrated process which can be broken down into four stages, as follows:- 1. Generation; 2. Transmission; 3. Distribution; 4. Supply to individual customers. 2.2. The first and last of these activities is potentially competitive. In contrast the transmission and distribution systems are natural monopolies. Thus one of the key characteristics of the industry is the fact that it combines naturally monopolistic activities with potentially competitive features. Natural monopolies arise where economies of scale are such that the production level corresponding to the lowest unit cost of the firm is sufficient to meet total market demand when price equals that unit cost. 2.3. A second feature of the electricity industry is that demand fluctuates systematically during the course of each day, week and year. For example, business demand is concentrated during working hours, while domestic users consume more outside of working hours. Similarly demand is greater in winter than in summer. The bulk of the cost involved with catering for peak demand is the fixed cost of installing sufficient capacity to cope with such demand. Higher prices for peak use, peak-load pricing, are a common feature of utilities as they discourage more costly peak time usage, while helping to meet the higher cost of providing such services. 1 2.4. Demand may also fluctuate randomly in a way that is unpredictable. For example, demand for electricity will be higher on a particularly cold winter s night than on the average winter s night. This poses problems because capacity is fixed and output is largely nonstorable. 2 The situation is further complicated because supply is subject to unpredictable outages. Balance between supply and demand must be maintained constantly throughout the system otherwise non localised power outages or blackouts will occur. The need to maintain 1 For a more detailed analysis of peak load pricing see, S.V. Berg and J. Tschirhart, (1988), Natural Monopoly Regulation, Cambridge, Cambridge University Press. 2 This is not entirely accurate. Night storage heaters, for example, use off-peak power to produce heat at other times while pumped storage generating plants such as Turlough Hill represent a means of indirect storage. 5

constant balance between supply and demand requires very close co-ordination between generation and transmission and is a major reason why these two activities have traditionally been vertically integrated, although overseas evidence shows that such vertical separation is possible. Installed generating capacity has to exceed demand and indeed Fig.1 illustrates that present ESB generating capacity is well above the level of peak demand. Plant has to be up and ready to supply to cope with any sudden surge in demand or plant failure. This is referred to as spinning reserve. In addition to the requirement that some stations be run in order to meet spinning reserve requirements, start-up costs mean that it may be better to keep stations running even when they are not producing, rather than shutting them down and starting them up again. Fig.1: Peak Electricity Demand as % of Installed Generating Capacity 75 70 65 60 55 50 1988 1989 1990 1991 1992 1993 1994 Source: ESB Annual Reports 2.5. The trade-off between installing sufficient capacity to meet any conceivable level of demand and the cost of failures arising from inadequate capacity can be resolved in a number of ways. One alternative is differential pricing. Thus industrial users can be offered a choice between a high price with supply guaranteed and a lower price with some risk that if demand exceeds capacity their supply will be cut off. The higher firm supply price means that consumers who value the service most will choose this option. Those users who are only prepared to pay the lower interruptible price, because they place a lower value on having a guaranteed supply, will be the first to be cut off if supplies are inadequate to meet demand. Such a system of firm and interruptible tariffs is operated by British Gas, for example. An alternative, in theory at least, would be to offer real time tariffs where the price of the service at any time responds continuously in an attempt to balance demand and available capacity. Such a pricing system would require that consumers be constantly aware of the price, possibly by means of having prices displayed on electricity meters. Clearly this would involve very substantial investment costs. A third means of dealing with such problems 6

would be through imports which is now an option following the restoration of the interconnector to Northern Ireland. 2.6. Electricity systems generally use a mixture of different plant types with a diversity of fuels. Fig.2 gives details of ESB installed generating capacity and electricity production by fuel type. Coal accounted for 42 per cent of electricity generated in 1992, compared to just 1 per cent in 1983/84 due to the construction and commissioning of the Moneypoint coal burning station. Hydro accounted for only 5 per cent of total generation with the remaining 53 per cent spread between gas, oil and peat. Very small generating units have traditionally been regarded as inefficient with estimates that capacity of around 400 MW was the minimum efficient scale for fossil fuel generating plants. 3 Technological changes, however, have changed the picture considerably. Combined cycle gas turbines (CCGTs), which combine simple gas turbines with a heat recovery steam generator, have increased thermal efficiency and reduced minimum efficient plant size. Estimates of minimum efficient plant size for CCGT generating plants range from 50 to 350MW, while some authors suggest that it may be even lower. 4 Fig.2: ESB generating capacity and output by fuel type 1992 45 40 35 30 25 20 15 10 5 0 % of Capacity % Of Production Oil Gas Peat Hydro Coal Note: 81% of gas plants can also burn oil. Source: ESB. 2.7. Generating plant has a long life span. 5 As a result current installed generating plants are the result of accumulated investment decisions over a long period of time. During that period relative prices, technology, projected future demand, environmental regulation, population and industrial structure have all undergone significant changes. As a result the 3 M. Armstrong, S. Cowan and J. Vickers, (1994), Regulatory Reform: Economic Analysis and the British Experience, Cambridge, MA., MIT Press. 4 On this point see C. Bayless, (1994), Less is More - Why Gas Turbines Will Transform Electric Utlities, Public Utilities Fortnightly, 1 December 1994. 5 At the end of 1992, over 25 per cent of the ESBs installed generating capacity was over 20 years old. 7

existing stock of installed generating capacity does not correspond with what would be considered optimal under present conditions. 2.8. The ratio of fixed to variable costs varies between the different types of generating plant. This is reflected in there being a ranking order for the dispatch of power by plants which is designed so as to minimise total costs. Plant tends to be brought into operation in ascending order of variable cost as demand rises. This means that plants with low variable and high fixed costs are operated as much as possible. Such generating capacity is referred to as base load. Those plants with high variable costs are operated to supply peak load. 2.9. In contrast to generation the transmission and distribution networks both constitute natural monopolies. By transmission we mean the high voltage nation-wide network of lines which carry power from the generating stations. The operation of the transmission system is a complex process and requires ongoing co-ordination of generation. Voltage and frequency fluctuations have to be maintained within a narrow band. Electric current flows along the line of least resistance rather than along a pre-determined path. This gives rise to what are known as loop flows in the transmission network. Consequently the supply of power to the grid by an individual generating plant will affect the flow of supplies from other plants so that there are significant externalities involved in the operation of the transmission grid. Nevertheless experience shows that it is possible to accommodate competing generators on the transmission network. Table 1: ESB Annual Capital Expenditure ( m) Year Generation Transmission Distribution General 1988 18 10 50 12 1989 12 5 54 14 1990 12 2 62 16 1991 24 2 70 20 1992 34 4 84 18 1993 35 8 106 21 1994 41 6 90 17 1995 10 16 100 22 1996 10 17 125 13 Source: ESB Annual Reports. 2.10. Distribution involves taking power from the high voltage transmission network, reducing voltage by means of transformers to levels suitable for industrial and domestic usage and then supplying power to individual homes and business premises by means of the 8

lower voltage local line network. Although distribution is a natural monopoly, because it involves local networks, such networks do not necessarily have to be owned by a single entity. Transmission and distribution of electricity both involve high sunk costs. Total ESB investment in the distribution system since 1988, for example, amounted to 740m. [See Table 1]. Electricity is costly to transport and a proportion is lost in the course of transmission and distribution. These losses occur because some electricity is dissipated as heat while it travels through conductors and when it is transformed from one voltage to another. Transmission losses increase with the level of use of the system and with distance. 2.11. The bulk of the cost of supplying electricity is accounted for by generating costs. UK data indicates that generation accounts for about 65 per cent of the total cost. Transmission and distribution account for 10 and 20 per cent respectively, while retailing costs account for the remaining five per cent. 6 Current Structure of the Electricity Supply Industry in Ireland. 2.12. The ESB is established by the Electricity Supply Board Act 1927 and it has a statutory monopoly of transmission, distribution and sale to the public. 7 Originally, electrical generation had been owned privately, but existing operations were acquired successively by the ESB. Currently the ESB owns virtually all of the generating plant along with the transmission and distribution network. In effect the ESB is a vertically integrated monopoly. This is because the government response to the natural monopoly aspect of the transmission/distribution network was to extend the monopoly into the downstream supply markets and upstream generating market. This pattern was common in many European countries. In contrast in the United States private ownership of such industries was the norm with the potential for abuse of market power due to the natural monopoly elements of the industry being dealt with by means of regulatory controls. 2.13. The ESB has power to make orders affecting and to issue permits to any new "permitted undertakings" to generate, distribute or supply, so that new entry into the generation business has effectively been prevented. There are, however, some independent electricity generators within the State. These include suppliers who currently sell power to the ESB and firms who generate their own electricity. In 1992, for example, purchases of electricity by the ESB from small suppliers amounted to 34.4 million units which represented just 0.2 per cent of sent out load. There are also some large industrial concerns in the State which generate their own electricity. Some of these might have some spare capacity and 6 D.M. Newberry and Green, (1995), Regulatory Policies and Reform in the Electricity Supply Industry, in C.R. Frischtak, ed., Regulatory Policies and Reform: A Comparative Perspective, World Bank. 7 1927 Act, ss.35,37, 61. 9

might be capable of selling power to other users. Other fuels constitute substitutes to electricity for certain purposes. Gas for example is a substitute for various forms of heating. Technological developments mean that combined heat and power (CHP) plants fired by CCGTs may enable a growing number of firms to generate their own electricity. In effect firms could substitute electricity generated in house from CCGTs for purchased electricity. 2.14. The ESB s operations are regulated by specific Acts of the Oireachtas. These require inter alia that proposals for price increases must be approved by the Government. Section 21 of the Electricity Supply Act 1927 requires the ESB to operate on a break even basis. Like other state enterprises it has not always been permitted to operate on a purely commercial footing. In its 1994 Annual Report, the Chairman of the ESB stated that the development of the ESB requires from the Government, as owner, a commercial freedom which has not been forthcoming during the company s history to date. In January 1995 the Minister for Transport Energy and Communications told the Dail that an ESB application for a price increase had been with the Department for seven years. 8 Table 2: Electricity production and sales various years. Year Units Sold Average Price Customers ( 000) Staff ( 000) 9 millions per Unit Sold (p) 1985/86 9788 7.736 1195 12114 1986(a) 7295 7.548 1207 11763 1987 10506 7.010 1222 11383 1988 10616 6.666 1235 10903 1989 11169 6.542 1257 10724 1990 11768 6.425 1279 10490 1991 12370 6.348 1302 10096 1992 13104 6.307 1327 10340 1993 13439 6.269 1348 10028 1994 14025 6.238 1376 9784 1995 14699 6.212 1408 9702 1996 15707 6.236 1442 9313 % change 1985/86-1996 +60.4-19.4 +20.7-23.1 Source: CSO; Statistical Abstract 1993, Table 14.7, and ESB annual reports. 2.15. Table 2 gives details of trends in electricity generation, sales and revenue over time. Total electricity sales in 1996 amounted to 15707 million units an increase of 6.9 per cent on 8 Dail Reports, 21 February 1995, Col. 870. 9 The staff numbers given for recent years are those given as employed in supply, retail and contracts and excludes other activities. The figures for recent years may therefore not be wholly consistent with those for earlier years. 10

the previous year. Since 1985/86 total electricity sales have increased by 60 per cent while ESB customer numbers have grown by 21 per cent. Over the same period staff numbers have fallen by 23 per cent, while the average price per unit of electricity sold has fallen by 19 per cent in nominal terms or almost 40 per cent in real terms. The fall in prices reflects the significant gains in productivity which have been achieved but also gives some indication that prices in the past were somewhat high. The fall in price has also occurred in part at least because of the Government s failure to sanction any price increase in spite of applications by the ESB. 2.16. Fig.3 illustrates the pattern of electricity consumption. The domestic and industrial sectors each accounted for around 38 per cent of total electricity consumption in 1994 with the commercial sector accounting for the balance. Fig.3: Distribution of Electricity Sales in 1994. Commercial 25% Industrial 38% Domestic 37% Source: ESB, Annual Report, 1994. 2.17. Fig.4 illustrates that productivity measured both in terms of units sold or customers per employee has increased considerably. 11

Fig.4: ESB Productivity (1985/86 = 100) 190 170 150 130 110 90 Units sold per employee Customers per employee 70 1985/86 1986 1987 1988 1989 1990 1991 1992 1993 1994 Source: CSO and ESB Annual Reports 12

Chapter 3 EU Directive 96/92/EC on common rules for the internal market in electricity. 3.1. EU Directive 96/92/EC came into force in February 1997. The Directive is designed to provide for greater competition or liberalisation of the electricity market throughout the European Union. The Directive establishes common rules for the generation, transmission and distribution of electricity. It lays down the rules relating to the organisation and functioning of the electricity sector, access to the market, the criteria and procedures applicable to calls for tender and the granting of authorisations and the operation of systems. 10 3.2. In the case of generation the Directive provides that Member States may choose between an authorisation and/or a tendering procedure for the construction of new generating capacity. Authorisation and tendering must be conducted in accordance with objective, transparent and non-discriminatory criteria. 11 The Directive specifies a number of requirements for the operation of both authorisation and tendering procedures. 12 In addition it sets down the rules for the operation of the transmission and distribution systems. These provide inter alia that Member States shall designate or require undertakings which own transmission systems to designate for a period of time a system operator to be responsible for operating, ensuring the maintenance of, and, if necessary, developing the transmission system in a given area and its interconnection with other systems, in order to guarantee security of supply. 13 The system operator may not discriminate between system users and, unless the transmission system is already independent of generation and distribution activities, the system operator must be independent, at least in management terms, from the other activities not relating to the transmission system. 14 Similar provisions apply to distribution. 15 Integrated electricity undertakings are required to keep separate accounts for their generation, transmission and distribution activities with a view to avoiding discrimination, cross subsidisation and distortion of competition. 16 The Directive provides that Member States may choose between allowing third party access to the electricity system or establish a Single Buyer regime. 17 The Single Buyer regime, where adopted, must comply with certain criteria including, inter alia, that: 10 Article 1. 11 Article 4. 12 Articles 5 and 6. 13 Article 7.1. 14 Articles 7.5 and 7.6. 15 Articles 10 and 11. 16 Article 14.3. 17 Articles 16-18. 13

large customers would be able to negotiate directly with independent producers and importers; the Single Buyer would act as a transparent mechanism for the transport of electricity bought by such direct negotiation; the Single Buyer would be obliged to buy all electricity offered; distributors, as well as large customers, would be eligible to buy from the Single Buyer. 18 3.3. It is important to state that literal compliance with EU requirements would fall short of providing an institution with overall responsibility for promoting competition in the electricity industry. There is a requirement that authorisation and tendering procedures for commissioning new generating capacity must be conducted in accordance with objective, transparent and non-discriminatory criteria. Such a procedure must satisfy the needs of different parties but must also operate in the public interest. At the very least the system ought to be sufficiently certain so as not to discourage potential entrants. However, the overriding criterion should be that the regime chosen is genuinely effective in promoting competition. 18 Article 18. 14

Chapter 4 Proposals made by the Department of Transport, Energy and Communications. 4.1. The Consultation Paper sets out the Department s proposals for the development of the electricity supply industry in Ireland. It includes a number of provisions in respect of generation, transmission and distribution and access to the system. It states that the proposed structure of the industry needs to be sustainable in the long term. Thus the structure would need to: be secure against legal challenges; maintain ESB s financial viability (so long as it operates efficiently); and remain viable under substantial entry of new undertakings. 4.2. As noted above the EU Directive provides that construction of new generating capacity may be on the basis of either an authorisation and/or a tendering procedure. The Consultation Paper states that: The Government has previously decided that the tendering procedure should be used for the construction of new generating capacity. Under this regime, only independent producers and autoproducers will be able to apply for authorisations. (p. 6) 4.3. The Power Procurer will decide when new capacity is required and it will invite tenders for the provision of such capacity. It will then enter into Power Purchase Agreements (PPAs) to purchase the output of such plants. The ESB s Generating Business will be permitted to compete in tenders for new plant. 4.4. The paper also proposes to establish a new Transmission System Operator (TSO) which would be a publicly owned company independent of the ESB. However, the paper also states that it has been agreed that ESB should remain vertically integrated insofar as this is possible within the constraints of the Directive (p.7), while the ESB s Transmission Business will own all the transmission assets in Ireland, including such extensions as may be constructed. The construction of such extensions will be put out to tender by the TSO and the ESB s transmission business may compete in such tenders. The ESB s Transmission Business will also initially be responsible for maintenance of transmission assets and may tender to continue this role when requested to do so by the TSO. (P.10) The TSO s functions will be to plan and operate the transmission system, contract for its maintenance and development at best value for money, for the non-discriminatory dispatch of generating sets and the scheduling of their planned outages and for ensuring provision of ancillary services including voltage and frequency stability through contracting with generators. 15

4.5. The Directive requires separation of accounts of the businesses of generation, transmission and distribution. The Department is also recommending that the ESB s Supply Business keep separate accounts so that the costs of supplying retail customers can be separately identified. There will be a published tariff for the use of the transmission and distribution system. 4.6. The Department proposes to opt for the single buyer system and proposes that the ESB s Power Procurement Business be designated the Single Buyer. The Directive requires that Member States specify customers with a total demand initially amounting to around 22 per cent of the total Gwh consumed, as eligible customers. Such customers will be able to negotiate directly with power suppliers. Over time the share of the market represented by eligible customers must increase to 28 per cent by the year 2000 and to 32 per cent by the year 2003. The Consultation Paper provides that the Power Procurer would sign Power Purchase Agreements (PPAs) with ESB s existing generators to purchase all of their output. The terms of these PPAs are to be reviewed every five years, but there is no clear provision for termination on purely economic grounds. They appear to last for the lifetime of the plant. The TSO may tender for new capacity when needed and such capacity would also be subject to PPAs and it may purchase electricity in the wholesale market. It will sell power to the Supply Business. It will also effectively sell to eligible customers and independent suppliers all the electricity they require at the wholesale market tariff. Although an eligible customer may contract with another supplier for the purchase of electricity, it will be required to sell that electricity to the Power Procurer at the same wholesale market tariff. 4.7. The Consultation Paper provides that the ESB s Distribution Business will own the distribution assets in Ireland and will be responsible for operating, maintaining, planning and developing those assets. The ESB s Supply Business will purchase generation from the Power Procurer and will set the retail tariff. Uniform tariffs must be charged and the paper states that the same price will be charged for the same service on average, regardless of the type of customer. The retail tariff must be approved by a Regulator. The paper also provides that independent suppliers will be free to enter to serve eligible customers and that the Power Procurer will effectively sell to such suppliers all the electricity they require at the wholesale market tariff. 4.8. Generating capacity belonging to Independent Power Producers (IPPs) may come onto the system through the authorisation process. IPPs will have to supply kwh prices to the TSO once a month, so that the TSO can ensure efficient dispatch of the system. IPPs may bid in tenders for new capacity. Independent suppliers will be free to enter to serve eligible 16

customers, while autoproducers may gain access to the network to supply any premises which they own. 4.9. The paper also provides for the establishment of a new independent Regulator for the industry. It states that: It is clear that this structure requires strong regulation because of the dominant position of the ESB, the integrated electricity utility, in all aspects of the industry. (P.13) The Regulator s duties will include: regulating the conduct of the electricity industry including prevention of abuses of dominant position; reviewing contracts between ESB s generating business and the Power Procurer; setting the price caps and quality standards for the parts of the business that are natural monopolies; regulating tenders for new plant; generating authorisations for new capacity; approving the wholesale tariff set by the TSO; and, approving the retail tariff set by ESB s Supply Business. 4.10. The paper also sets out the basis on which wholesale and retail tariffs are to be set. In the case of wholesale tariffs the paper states that these will determine the prices at which differences between the output of generators and the load of their contracted customers are traded. It goes on to state that there needs to be an incentive for IPPs to be available at times of short supply so that the wholesale price at these times must be no less than the running costs of the most expensive set on the system (excluding most-run sets). The paper also states that the structure of wholesale prices needs to be such as to ensure that no one has an incentive to encourage inefficient despatch. The implication according to the paper, is that wholesale market prices generally need to reflect the running costs of the most expensive set generating, and that there should be little or no uplift between the wholesale market purchase and selling prices. Accordingly it states that the wholesale market price at any time in the day, week or year needs to be system marginal running costs. 4.11. Retail tariffs are to be set by the ESB s Supply Business at a level such that the sum of the costs to the Power Procurer of purchasing generation under the PPAs and the net costs of the Power Procurer s trades in the wholesale market less stranded capacity costs are expected to be precisely recovered. 19 Stranded capacity would be valued at the capacity cost of an open cycle gas turbine and the resulting sum is to be subtracted from the revenue to 19 Stranded capacity is surplus generating capacity deemed by the Regulator to be stranded. 17

be recovered for the purpose of the retail tariff. A small charge to cover the Supply Business costs and profit margins is to be added to the cost of the units purchased through the supply business. 4.12. In addition certain public service obligations must be met. These include a requirement that there be uniform tariffs for certain customer classes and certain requirements in respect of the use of peat fired stations and renewable energy. Additional charges will be spread across all producers to recoup the costs of such obligations. 4.13. The consultation paper also includes some estimates on the price implications of the new procedure based on 1992 data for the ESBs operations. It concludes that the average price for delivered power under the new system would probably have been broadly the same as the actual price, at 6.3p/kWH in 1992. (P.19) 18

Chapter 5 Market Structure and Competition. Introduction. 5.1. The publication of the consultation paper by the Department of Transport, Energy and Communications is a welcome development. The liberalisation of the electricity market has far reaching implications and, in the Authority s opinion, it is appropriate that there should be a broad debate on the various policy options. In this respect the paper is perhaps rather brief and a number of serious policy issues are not addressed. A further problem with the paper is the fact that a number of the proposals appear somewhat vague and unclear. The Authority believes that greater emphasis should be placed on promoting competition in the industry as a desirable objective. The Case for Competition. 5.2. In most industries competition between individual producers results in the production of the highest possible level of output at the lowest possible cost. In contrast monopolies have generally been identified as inefficient, resulting in higher prices and lower levels of output compared with competitive markets. Monopolies impose significant unnecessary costs on society. Higher monopoly prices reduce consumer surplus and result in dead-weight losses to society. Monopolists face less incentives to operate efficiently leading to what has been described as X-inefficiency. Monopolists also have an incentive to engage in rent-seeking behaviour in an attempt to maintain their monopoly position. Such behaviour is wasteful from the perspective of the economy at large. In addition, because of their monopoly status and their key position in the economy as providers of essential services to business and consumers, there will generally be a demand for regulation in some form or other to prevent monopoly utilities from abusing their dominant position. The resources employed in such regulatory regimes represent a further cost to society of monopoly in such industries. Lack of competition allows monopolists to continue producing poor quality/high cost services while still keeping their customers. In the case of a small open economy such as Ireland, inefficiencies attributable to monopolies adversely affect the cost structure facing the traded goods sector, thus undermining its ability to compete with foreign competitors. This has serious adverse consequences for employment in the traded sector and in the economy as a whole. 5.3. In the case of natural monopolies economies of scale mean that a monopoly will be more efficient than several competing firms. In these circumstances average costs would be 19

lower in the case of a monopoly than they would be in a competitive market. It is therefore possible, that where a natural monopoly exists, prices under monopoly would be lower than those which would result from competition. However, as Scherer and Ross point out very few industries actually constitute natural monopolies. 20 In the case of the electricity industry, while some activities are natural monopolies others are not. 5.4. Given that the generation and supply elements of the electricity industry are potentially competitive, it would appear that permitting competition in such areas would prove to be economically beneficial. This is confirmed by experience of liberalisation of electricity markets in other countries which shows that competition has resulted in increased efficiency, lower prices and improved quality and range of services to consumers. 5.5. In the case of electricity in the UK, large customers bills have fallen by 10 per cent on average in real terms while prices to smaller customers are down by 4.5 per cent. 21 Henney 22 also found that liberalisation of the electricity industry in the UK, while suffering from certain shortcomings, nevertheless represented an improvement on the previous regime where generation was confined to a monopoly producer. Experience in New Zealand, where firms have been permitted to generate and/or transmit electricity in competition with the state owned ElectriCorp since 1988, again shows that costs and prices have fallen significantly. Between 1987 and 1993 average wholesale prices fell by 15 per cent in real terms. 23 Spicer, et. al. 24 found that output per employee was substantially higher, while the improvement in performance was not achieved at the expense of quality of service. 25 5.6. It is sometimes suggested that competition in utilities would not represent an efficient outcome in an economy as small as Ireland. Claims that competition would not be efficient in small countries ignore the fact that many small countries have permitted greater competition in utilities in recent years. New Zealand is one example which has already been referred to. In Finland the Electricity Market Act which came into force on 1 June 1995 opened up the production and distribution of electricity to competition. Major electricity users are now permitted to buy electricity from any producer or distributor and households will be able to 20 F.M. Scherer and D. Ross, (1990), Industrial Market Structure and Economic Performance, 3rd edition, New York, Houghton-Mifflin. 21 R. Green, (1995), Competition in the British Electricity Industry, ESRI, mimeo. 22 A. Henney, (1994), A Study of the Privatisation of the Electricity Supply Industry in England and Wales, London, EEE Ltd. Henney, (1994). 23 Wholesale Electricity Market Development Group (WEMDG), [1994], New Zealand Wholesale Electricity Market, Wellington, Government Printer. 24 B. Spicer, R. Bowman, D. Emmanuel and A. Hunt, (1991), The Power to Manage: Restructuring the New Zealand Electricity Department as a State Owned Enterprise _ The Electricorp Experience, Oxford, Oxford University Press. 25 For a more detailed review of the benefits accruing from introducing competition in public utility industries see OECD, (1997), Regulatory Reform Project, Paris, OECD, forthcoming. 20

choose between competing suppliers after two years. Following a change of Government in Sweden the deregulation of the electricity market was postponed to allow for a further review of the implications for smaller distributors and consumers. The Energy Commission, which conducted the review, concluded that deregulation should proceed as soon as possible. Australia has also introduced major changes in the operation of public utilities in the light of the proposals contained in the Hilmer Report on National Competition Policy. The Report recommended that: 1. Regulatory and commercial functions should be separated; 2. Natural monopoly activities should be separated from contestable ones; and 3. Potentially contestable activities should be separated into several independent competing businesses. International experience has shown that electricity systems that are regulated, state managed or controlled, and/or non-competitive do not deliver electricity or security of supply at the lowest possible cost and price to consumers. Such systems are also economically inefficient. 26 5.7. It is often erroneously claimed that introducing competition in the case of public utilities will lead to a decline in employment. The reality is that introducing competition in public utilities is likely to impact on employment within the economy in several ways. Pressures on incumbent firms to increase efficiency and reduce costs in response to increased competition is likely to involve some job losses in such firms. This will be partly offset by new competitors entering the market and creating new jobs. In addition, to the extent that competition leads to lower prices, demand for the output of the industry may be expected to increase and this will also have a positive impact on employment in the sector. Finally by reducing costs to the traded sector, increased competition will result in employment gains in that sector of the economy. Fitzgerald and Johnston 27 report that simulations using the ESRI medium-term model suggest that the initial impact of a cut in costs in the energy utilities would be to reduce employment by about 3000 in the first year but that the loss of employment in utilities would be offset by increased employment in other sectors in future years. 5.8. The Authority believes that greater competition in the electricity market would benefit electricity users and the economy generally. The view that greater competition is desirable 26 Supra note 23, p.15 27 J. Fitzgerald and J. Johnston, (1995), Restructuring Irish Energy Utilities, ESRI, mimeo. 21

has previously been expressed in a number of official reports. For example, the Culliton Report on Industrial Policy recommended that the utilities should be opened up to competition. 28 More recently Forfas called for greater competition in energy supply to be introduced by permitting independent generators to compete in the market. It argued that the objectives of energy policy should be to achieve security of supply while ensuring that costs were competitive with those in Ireland s main trading partners; to achieve greater efficiency in use and to minimise the environmental impact of energy provision and consumption. It then concluded that: These objectives can best be pursued through the liberalisation of markets with minimum regulation. 29 5.9. Having analysed the impact of the proposed regime, on the basis of 1992 data, the Consultation Paper concludes that under the proposed regime generating costs and electricity prices would be more or less in line with actual prices. This is perhaps a somewhat surprising outcome. In recent years the ESB has introduced major changes designed to improve efficiency and reduce costs. By definition one would assume that electricity prices in 1992 included some level of inefficiencies. Certainly a more competitive regime should put pressure on firms to cut costs and eliminate inefficiencies. 5.10. It must be conceded that competition may suffer from certain shortcomings. The fact that the outcome under competition might fall some way short of the ideal solution does not mean that it is not a desirable option. The question is whether competition can produce a superior outcome to that achieved under a regulated monopoly. While the EU Directive sets out a basic framework for liberalising the electricity sector, it affords considerable scope to individual Member States to determine the pace and extent of change. Given that increased competition may be expected to result in lower prices, those countries which proceed fastest in terms of introducing competition are likely to gain a competitive advantage over others. If Ireland adopts a more restrictive approach then domestic firms are likely ultimately to face higher electricity prices than their rivals in other Member States. This would obviously be an undesirable outcome. 5.11. A second issue which is not addressed at all in the paper is the question of competition between fuels. Arguably there has always some degree of competition between fuels in the past. However, the nature of that competition may be changing as a result of technological developments. The development of CCGTs means that gas may no longer just be a substitute 28 J. Culliton, (1992), A time for Change: Industrial Policy for the 1990s: Report of the Industrial Policy Review Group, Dublin, Stationery Office. 29 Forfas, (1996), Shaping Our Future: A Strategy for Enterprise in Ireland in the 21st Century, Dublin, Forfas, p.238. 22

for electricity in certain end uses but that purchasing gas to generate electricity may be an alternative for many businesses to purchasing electricity. Structural Issues. (a) Vertical Integration. 5.12. As noted above the Consultation Paper provides that the ESB should remain a vertically integrated company albeit subject to strict requirements in respect of maintaining separate accounts for the different elements of the business. However, as Armstrong et. al. 30 have argued, deciding whether or not to separate vertically integrated monopolies is possibly the most important question for structure regulation. It would therefore be preferable if the Consultation Paper had devoted greater attention to the issues involved. 5.13. Experience in other countries indicates that in many instances liberalisation of the electricity industry was accompanied by the break-up of vertically integrated incumbent firms. This was the route followed, for example, in England and Wales, New Zealand, Norway, Sweden and the State of Victoria in Australia. In New Zealand the separation of the national grid into a separate independent firm was seen as essential for the introduction of competition into the electricity market. 31 Scott and Convery 32 argue that separating the transmission and distribution systems from production in the case of gas and electricity has the advantage that it is designed to allow and indeed encourage competition. In the case of Scotland where there are two vertically integrated electricity suppliers, it was found that new generating firms were much slower to enter the market, in contrast to the position in England and Wales where generation and transmission activities were disaggregated. 33 5.14. The primary issue is whether such vertical separation would lead to higher or lower electricity prices. If, for example, there are significant economies of scope arising from vertical integration, these will be lost in the event of a vertical split. In New Zealand the Electricity Task Force 34 concluded that the benefits from vertical separation outweighed the costs. Kaserman and Mayo 35 estimated that arms-length contracts between generators and 30 Supra note 3. 31 Electricity Task Force, (1989), Structure, Regulation and Ownership of the Electricity Industry, Wellington, NZ Government Printer. 32 S. Scott and F.M. Convery, (1990), Energy and Privatisation in Ireland in F. Convery and M. McDowell, eds., Privatisation: Issues of Principle and Implementation in Ireland, Dublin, Gill and Macmillan. 33 S.C. Littlechild, (1996), Privatisation, Competition and Regulation in the Scottish Electricity Industry, Scottish Journal of Political Economy, 43, 1-15. 34 Supra note 31. 35 D. Kaserman and J. Mayo (1991), The Measurement of Vertical Economies and the Efficient Structure of the Electric Utility Business, Journal of Industrial Economics, 39, 483-502. 23

suppliers add almost 12 per cent to US electricity prices compared to vertically integrated production. The overseas evidence is therefore mixed. The Authority believes that it would have been preferable to have undertaken a detailed review of the costs of both options before taking a final decision on the issue of whether the ESB should remain vertically integrated. 5.15. A second consideration is the fact that vertical separation of transmission and distribution networks from generation considerably reduces some of the problems associated with regulating the industry. This is because independent operators of transmission and distribution systems do not have the same incentive as a vertically integrated firm to discriminate against new firms providing services in competition with the incumbent over their networks. Even if it were in the incumbent owner s interest to allow competing entry because its owner s losses from increased competition in the downstream market would be outweighed by gains from access revenues and enhanced internal efficiency, principal-agent problems may still lead the firm s managers to refuse to deal. Particularly in public enterprises with a long history of public ownership, managers may be output or employment maximisers, more interested in retaining market share than in increasing shareholder value. Being risk-averse, the incumbent s managers may weigh the certain loss of a quiet life far more heavily than the uncertain gains they could secure from operating in a competitive environment...as a result the firm s managers may stall or obstruct access by the entrant even when such access would have been granted by the facility s owners. 36 5.16. Experience from other industries serves to illustrate the point. Stern 37 claims that incumbent firms in the gas industry throughout Europe deliberately exaggerated the problems and advanced obscure technological arguments to block proposals that EU member states grant gas suppliers from other states access to their networks. In the UK it took almost four years of negotiations to secure agreement on the question of access charges permitting Mercury to enter the market in competition with British Telecom. Similarly in New Zealand disputes between Telecom New Zealand and Clear Communications relating to access charges for the local loop were only resolved after a long drawn out court battle which was ultimately decided by the Privy Council in London. 5.17. The EU Directive attempts to deal with this by requiring that, at the very least, the different elements within vertically integrated firms must maintain separate accounts. It is not 36 H. Ergas, (1995), Access and Interconnection in Public Utilities, Centre for Research in Network Economics and Communications, University of Auckland, mimeo. 37 J. Stern, (1992), Third Party Access in European Gas Industries, London, Royal Institute of International Affairs. 24

clear, however, that this represents an effective compromise. Armstrong et. al. 38 point out that partial separation involving the establishment of separate subsidiaries with separate accounts may or may not be able to ease the problem of regulating access charges of a vertically integrated firm. At best the efficacy of such measures remains untested and are likely to require any regulatory agency to be particularly vigilant. 5.18. There is a further benefit to vertical separation in the case of the distribution network. It would permit the possibility of establishing several local distribution companies for different parts of the country. One benefit of the creation of several local distribution firms is that it would allow the possibility of yardstick competition. Yardstick competition represents a useful means for overcoming the problem of information asymmetries between the regulator and regulated firms. This can be done by making the reward to individual firms dependent on their performance relative to that of other similar firms. 5.19. The Authority believes that a more detailed debate on these issues would be appropriate before any final decision is taken on whether the ESB should remain vertically integrated. 5.20. Although the Consultation Paper talks about independent suppliers, it is unclear how it is proposed that they would operate. The issue receives little attention in the document in which there is no discussion on how such suppliers would gain access to the network. (b) The Single Buyer. 5.21. The paper states that the Government has decided to opt for the single buyer option as opposed to the third party access option. Again there is little discussion or analysis in the paper of the alternative options. It is simply presented as something that has been decided. 5.22. Eligible customers will, as noted, be able to enter into agreements with IPPs. However, they will be required to sell to the single buyer and then effectively buy back at the wholesale price. It is not clear what incentive there will be for eligible customers to enter into agreements with IPPs since it is not clear to what extent the proposals would allow them to buy electricity at a lower price than from the single buyer. 5.23. The alternative to the single buyer model is to permit third party access by allowing IPPs to supply directly to customers using the transmission and distribution grid. Such an option is permitted under the EU Directive. A further option or variant on the access model would involve the establishment of a wholesale electricity market where suppliers and 38 Supra note 3. 25