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The energy dilemma

Updated Tuesday, 26th August 2014

How can the Government balance voter and industry expectations of the energy market in the lead up to the next election?

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Gas ring Creative commons image Icon Lee Haywood under CC BY-SA 2.0 license under Creative-Commons license The current Government faces a dilemma when it decides how to respond to voters who ask “what are you doing about high energy prices?” Media coverage shows that voters expect energy prices to be significantly lower than they ar particularly at a time when energy companies are repeatedly reporting ‘excessive’ profits.

The Government’s decision to launch the Competition and Markets Authority (CMA) probe into the structure of competition in the electricity industry is evidently prompted by these concerns. They are also no doubt prompted by the political capital created by Labour’s suggestion that it will freeze energy prices should it win the 2015 election

However the Government no longer sets energy prices although it can still shape the competitive environment. It is the competitive structure of the industry, rather than pricing, that is the focus of the review. In short the review is asking whether UK energy competition is as effective as it could be and what reforms might be necessary to make competition more effective (which could lead to lower prices).

However the wider context of an impending energy crisis, as existing nuclear and fossil fuel power stations come to the end of their lives, deepens the Government’s dilemma. In this context any future government will need energy companies to feel confident enough about their potential to generate profits to invest in new infrastructure to keep the lights on.

In this context reforming the industry, changing the rules halfway through the game, may undermine the willingness of foreign or UK owned companies to support infrastructure investments or even to remain in the industry. Balancing voter and industry expectations may therefore pose a real challenge.  However the CMA review has a potentially wider significance as it might question the longstanding dominance of the market as the mechanism for deciding prices in UK network industries. The liberalisation of the electricity industry was a key event in establishing the dominance of market mechanisms as it featured a design which aimed to ensure that the market, with as little interference from government or regulator as possible, set prices.

Any adjustment to the current competitive marketplace could be interpreted as a critique not only of the original reform but of the philosophy which underpinned it.

Prior to privatisation the UK had one body, the CEGB, which was responsible for the entire electricity supply chain (consisting of generation, transmission, distribution and supply). The 1988 White Paper introduced an industry structure which was vertically and horizontally de-integrated creating a four separate industries and a large number of separate companies to deliver different services.

In particular separating and then opening up the key industries of generation and supply to competition was expected to enable market forces to deliver better quality at lower prices. However it is probable that if they had been asked to predict the future, the architects of the original privatisation might have imagined an industry which looks remarkably similar to the one we have now.

The starting structure was designed to engineer competition with a large number of smaller companies. However as the industry evolved it was expected that regulatory change would permit a smaller number of larger companies to emerge as companies engaged in both horizontal and vertical merger as business demands dictated.

The current design, with the ‘Big Six’ energy companies dominating the industry, is therefore arguably a natural consequence of this original philosophy. The architects also designed a regulatory framework, where Government played an increasingly limited role, and where the market was free to determine a fair price.

The pricing structure which has emerged is therefore also arguably a natural consequence of the original design and reflects what the market believes is a fair price for the services offered.

In this context, companies re-integrating generation and supply was therefore not only entirely predictable but actually a design feature of the original legislation. Any move to change the rules governing industry structure, once again enforcing a separation of generation and supply, is arguably a fundamental critique of the original regulatory design perhaps reflecting the changed political climate we live in.

When electricity was privatised faith in the effectiveness of the market was arguably greater than it is after the financial crisis where faith in markets is perhaps at low ebb. It is worth noting that calls for Government to rectify market failures (or perceived market failures because market advocates would argue that they are not failing) can also be heard from other network industries such as rail and telecoms.

However future governments, even of the centre-left, are unlikely to want to be as active in the delivery of network services as were governments prior to 1979 and this reinforces the underlying dilemma being faced; how much trust should be placed in markets when voter confidence in those markets has been so badly shaken?

What do you think? Share your comments below.

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