The Impact of Privatisation on Electricity Prices in Britain

Presentation to the IDEC National Seminar on Public Utilities

Sao Paulo, August 6-8, 2002

Steve Thomas

Senior Research Fellow

Public Service International Research Unit (PSIRU)
School of Computing and Mathematics
University of Greenwich
30 Park Row
London SE10 9LS
UK
Tel: 44 208 331 9056
Fax: 44 208 331 8665
Email: Stephen.thomas@gre.ac.uk
Website: www.psiru.org

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 The Impact of Privatisation on Electricity Prices in the UK
Consumers basically want two things from their electricity supplier: reliability of service and affordable
prices. By these criteria, electricity privatisation in Britain appears to have been a success: since
privatisation in 1990, reliability has remained excellent and prices to small consumers have fallen in real
terms by about 25 per cent. This presentation focuses on the impact of privatisation on prices paid by
small consumers, identifying why changes in price have occurred. The presentation falls into five main
sections;
• The component parts of electricity bills and how they are calculated;
• Prices from 1990-98, when small consumers were still captive to their local retail supply
(commercialisation) company;
• Prices from 1999 onwards, when small consumers were able to choose their electricity supplier;
• The role of pre-payment meters (PPMs) in the privatised industry; and
• The potential impact of structural changes currently underway to the industry.

1. The component parts of electricity bills

After privatisation, there were five main components to electricity bills. These were: generation,
distribution, transmission, retail supply and a nuclear subsidy. Each was derived by a separate
mechanism.

1.1 Generation
In Britain, generation is split between gas, coal and nuclear power. In 1990, about 75 pe4r cent of power
came from coal and most of the rest was nuclear. Now, coal and gas account for about 35 per cent each of
generation, with the rest mostly nuclear. Generation represents the largest element of consumers’
electricity bills accounting for about half the cost. The change to the way in which generation was priced
was the most radical and most important element of the 1990 reforms. Power generation was to be
operated as a competitive market rather than as a monopoly. In the original design, the market (Power
Pool) was a compulsory one with prices changing every half hour. In 2001, the Power Pool was replaced
by the New Electricity Trading Arrangements (NETA), in which long-term contracts were expected to
play the dominant role. While small consumers were captive to their local retail supply company, the
retail supply company could only pass on to consumers the price they had paid for electricity from the
wholesale market. However, they were able to allocate different purchases to different markets, and, for
example, retail suppliers allocated their expensive electricity purchases to the captive market, while
saving their cheaper purchases for consumers that were able to chose their electricity supplier.
Now, the overall tariff is unregulated and, effectively, retail supply companies are not restricted in what
generation charges they can pass on to consumers.

1.2 Transmission and distribution

The charges for use of the transmission and distribution system represented about 5 per cent and 25 per
cent respectively of the bill for a small consumers. These two sectors were to remain monopolies and the
price charged to generators and retail suppliers for using the networks was to be set by an independent
regulator using incentive (‘RPI-X’) methods.
The methodology was originally very simple and required only that the Regulator set the regulated
company an annual target for improving its efficiency that would apply for 3-5 years forward: the ‘X’
factor. It was entirely the business of the company how it achieved the target, through investment in new
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equipment or productivity improvements. If the company could beat its target, it could keep the additional
profits it made and if it could not, its profits would fall, hence the description incentive regulation. The
results for the transmission sector are presented in Table 1. Overall, the reduction in prices since 1990 of
nearly 40 per cent is remarkable, but closer examination of the data shows that the price reductions
happened almost exclusively from 1997-2000, with one large price cut followed by three substantial cuts.
Table 1 Electricity Transmission Prices (1990=100)
Year X Price Mean X
1990 0 100
1991 0 100
1992 0 100 0
1993 3 97.0
1994 3 94.1
1995 3 91.3
1996 3 88.5 2
1997 20 70.8
1998 4 68.0
1999 4 65.2
2000 4 62.7 4.5
2001 0 62.7
2002 1.5 61.7
2003 1.5 60.8
2004 1.5 59.9
2005 1.5 59.0 3.5 (3.0)
To understand how these remarkable price cuts were possible, it is necessary to change in the method
used to derive ‘X’ that applied from 1995 onwards. By 1995, it was clear that prices could only be
reasonably set by reference to the value of the assets employed and the British system became a variant of
traditional rate of return regulation, although the results are still presented as an ‘X’ factor. Prices are set
using the formula:

Allowed income =
(Value of existing assets – Depreciation + New investment) * Rate of return + Operating expenditure

Each of the elements in this equation requires detailed and complex calculations, but the key factor in
driving price reductions has been the value assigned to existing assets. In 1990, the companies were sold
for only about a third of their accounting value. If the regulator had set the value of the pre-privatisation
assets at their accounting value, investors would have been able to make a full rate of return on three
times the amount they had actually paid for the companies. The Regulator therefore decided that the asset
value allocated to the pre-privatisation assets would be the price the companies were sold for. This
allowed large one-off price reductions when the system of price-setting was switched, in 1995 for
distribution and in 1997 for transmission.
There are two important points to note. First, these price reductions were paid for by taxpayers because
assets owned by taxpayers were sold for only a small fraction of their real value. Second, the price
reductions will probably only be temporary as prices will have to rise as old assets are replaced by new
assets paid for at the full market price. This trend is becoming apparent in the transmission sector and for
the period 2001-05, prices will fall by little more than 1 per cent per year.

1.3 Retail supply

These represent the costs incurred by the retail supplier and include metering and billing. At time of
privatisation, these represented about 5 per cent of a typical bill, but some costs have been reallocated

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from distribution to retail supply and the percentage is now more than 10 per cent. While small consumers
were captive to their local supplier, these charges were set by the regulator using incentive regulation
methods. Now, companies are free to charge whatever the market will bear. Because a retail supply
business has few physical assets, there was no scope for large price reductions from switching to rate-of-
return methodology.

1.4 The nuclear subsidy

Privatisation revealed that Britain’s nuclear power plants were heavy loss-makers and the plants could not
be privatised in 1990. They remained in public ownership and were subsidised by a consumer subsidy, the
Fossil Fuel Levy (FFL), the level of which was set by government. The FFL represented 10 per cent of all
consumers’ bills and about half the income of the nuclear company. By 1996, the efficiency of the nuclear
sector had improved and it was possible to privatise the more modern plants and remove the subsidy.
Losses made by the older plants are now underwritten by taxpayers.
In part, the removal of the nuclear subsidy was possible because of efficiency improvements in the
nuclear industry and this was welcome. However, it was possible partly because the burden of paying for
long-term costs such as radioactive waste disposal and decommissioning was shifted from today’s
electricity consumers to future generations of taxpayer. This runs counter to the ‘polluter pays’ principle
and cannot be regarded as equitable.

2. Prices from 1990-98

Four out of five of the elements of consumers’ bills from 1990 to 1998 were set by the regulator or
government and can be calculated. Given that the overall price was known, the remaining cost can only be
the price paid for generation. Table 2 shows how overall prices developed from 1990-98 and identifies the
elements within the overall bill that were responsible for the main changes in price. After early price rises,
prices began to fall from 1994 onwards. Prices rose steeply in the first year but then fell slightly in the
next four years so that by 1994/95, they were about the same as in 1990. In 1995 and 1996, sharp
reductions in the distribution charge reduced prices and in 1997, the effective removal of the nuclear
subsidy reduced prices still further. From the consumers’ point of view, these price reductions were
welcome, but they were only achieved because of reductions in monopoly charges, effectively paid for by
taxpayers, and by the removal of the FFL, which was possible because responsibility for nuclear liabilities
was shifted from the current to future generations.
Table 2 Components of a Bill
90/91 91/92 92/93 93/94 94/95 95/96 96/97 97/98
Typical bill (1990=100) 100 107.0 105.0 103.5 97.7 89.5 87.2 81.8
Distribution 25 25.2 25.4 25.6 25.8 22.2 19.3 18.7
Supply 6 6 6 6 5.9 5.8 5.6 5.5
Transmission 5 5 5 4.8 4.7 4.6 4.4 3.5
Total Monopoly Charge 36 36.2 36.4 36.4 36.4 32.6 29.3 27.7
FFL 10.6 11.8 11.6 10.3 9.8 8.9 8.7 1.8
Total Regulated Charge 46.6 48.0 48.0 46.7 46.2 41.5 38.0 29.5
Generation 53.4 59.0 57.0 56.8 51.5 48.0 49.2 52.3
(Typical bill – Regulated Charge)
Competition in generation failed to reduce generation prices. Generation prices fluctuated but overall, by
1998, were little lower than in 1990, despite reductions of 30-40 per cent in gas and coal prices
(generation from gas and coal accounts for about 70 per cent of generation in Britain). These price
reductions had partly been kept by generators as extra profits. The price reductions that were passed on
only went to consumers that were able to choose their electricity supplier, the medium and large
consumers. Medium and large consumers, who may have annual bills in excess of $1m, have the

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resources, the negotiating skills and incentive to identify and switch to the cheapest electricity supplier or
negotiate cheaper terms with their existing supplier.
The Regulator published data that showed how systematic the companies had been in allocating cheap
power to consumers that could choose and expensive power to those that could not (Table 3). Given that
he had a duty not to allow price discrimination between classes of consumers, it is not clear why he
allowed this to occur. He claimed that this price discrimination justified the introduction of retail
competition to small consumers. He said that if consumers could choose, they would switch to the
cheapest supplier and companies that offered high prices would lose market share and be forced to reduce
their prices or go out of business.
Table 3 REC Purchase Costs – 1996/97
Average price Quantity
(p/kWh) (TWh)
Franchise consumers
Coal contracts 3.92 71.7
IPP contracts 3.84 28.9
Other contracts 3.71 34.3
Average franchise purchase costs 3.85 134.9
Non-franchise purchase costs 3.00 80.4
Average total purchase costs 3.54 215.2
Source: Office of Electricity Regulation (1997) ‘The competitive electricity market from 1998: price restraints: proposals’
OFFER, Birmingham.

3. Prices from 1999 onwards

For electricity, Britain is divided into 14 regions, each with a different former monopoly supplier. After
mergers and take-overs amongst these 14 suppliers, there are just six remaining companies. There are now
about ten companies competing to supply electricity, the six remaining regional companies, British Gas
(the former nationalised gas supply company), and a few new entrants. The new entrants have made no
impact on the market for small consumers and can be discounted.
The computer systems necessary to allow retail competition for all 25 million British electricity
consumers were complex and expensive. The overall cost passed on to final consumers over five years
was about US$1.1bn and, three years after competition was introduced, there are still major practical
problems with data handling. There are also serious problems of unfair selling practices by competing
retail companies. Typically, companies acquire new customers using door-to-door or telephone sales staff.
Salesmen are paid by commission only and they therefore have a strong incentive to win new consumers
by any means they can. It is no surprise that they have a catalogue of unfair practices, including forging
signatures, and targeting vulnerable consumers. These practices should be easy to control and the
Regulator has repeatedly penalised companies for failing to control their sales staff. But three years after
electricity competition was introduced and five years after gas retail competition was introduced, they are
still occurring and the whole process of retail competition for energy has got a bad name with the public
as a result.
There were some minimal (ineffective) restrictions on the prices the incumbent suppliers were allowed to
charge from 1999-2001, but, basically, from 1999 onwards, retail suppliers have been able to charge
whatever the market will bear. Further large reductions in monopoly prices have meant that, overall,
prices have fallen somewhat. However, when we look at movements in the wholesale electricity price, it
is clear that the introduction of retail competition increased, not decreased the extent to which retail
supply companies exploit small consumers.
Since 1999, the wholesale electricity price has fallen by about 35 per cent. However, the price paid by
large consumers for generation has only fallen by 20 per cent and the price paid by small consumers has
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actually increased by 5 per cent. In 1997, the price paid by small consumers for generation was 5.8c/kWh.
Now, the published wholesale electricity price is about 2.2c/kWh. The total electricity price for small
consumers is now about 9c/kWh, so, arguably, small consumers are now paying nearly 4c/kWh too much
for their electricity. This has not become an issue because, overall, electricity prices are falling. There are
other services in Britain, such as rail and health care that clearly are failing, so the public is not interested
in services that appear on the surface to be working well.
This raises the question why is retail competition not working in the way the Regulator believed it would.
The answer is simply that, as a class, small consumers do not have the resources, the interest or the
incentive to switch frequently enough to force suppliers to reduce prices. In most countries where retail
competition has been introduced, rates of switching have been minimal. In Britain, experience has been
rather different and about a third of consumers have switched. The problem is that consumers are either
not switching on price grounds or they are unable to identify the cheapest supplier. If consumers do not
appear to be demanding low prices, the market is unlikely to offer them.
Most consumers that have switched now buy their electricity as part of a package of gas and electricity
from British Gas, the former national monopoly gas supplier. In most areas, British Gas is actually the
most expensive supplier in the market. Consumers probably believe (wrongly) they are getting a good
deal from British Gas but, for such an important purchase as electricity, they also want to deal only with a
tried and trusted supplier.

4. The role of pre-payment meters

4.1 PPMs in a privatised monopoly market
Pre-payment meters have played a key role in protecting (or at least appearing to protect) poor consumers
since privatisation. After its privatisation, British Gas adopted a much tougher stance towards consumers
that could not pay their bills, and the number of consumers cut off increased markedly, bringing the
process of privatisation into disrepute. To avoid this recurring with the electricity industry, a new type of
pre-payment meter operated with ‘smart cards’ individual to each consumer was introduced for
consumers with difficulty paying their bills.
The smart cards recorded the account details of the consumer and could be recharged at designated local
outlets, such as shops. This system is quite complex and while the retail companies did have the
advantage of being paid in advance for their power, the cost of the extra infrastructure (the new meter and
the connections at shops) was significant. The Regulator capped the extra cost that could be passed on to
PPM consumers requiring that PPM consumers pay no more than about 5 per cent more than standard rate
consumers. This did not concern the retail supply companies because any costs not recovered from PPM
consumers could be spread amongst other franchise consumers.
If the consumer had accumulated debt, some of the money paid by the consumer to charge the card went
to paying off the debt. For poor consumers, there were significant advantages with this system. They
could continue to receive a supply of electricity even if they had accumulated debt with their electricity
supplier. They also did not need to fear receiving a bill of unpredictable size once a quarter. This was a
useful advantage particularly for those pensioners that did not heat their dwellings adequately because of
the fear of receiving a bill they could not pay. Of course, if they really could not afford their bills, a PPM
does not help them. Nor do PPMs address the underlying problem of poverty.
PPMs also had an important advantage for retail electricity supply companies and the government. The
companies did not incur the expensive and politically damaging cost of cutting off consumers that could
not pay their bills. Consumers that could not pay their bill simply disconnected themselves by not
recharging their PPMs. The extent of the fuel poverty problem was masked. There is no ready way to
determine how many consumers are disconnecting themselves. Survey work is now carried out to
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determine the extent of the problem, but the accuracy of this work is questionable as consumers may be
too proud to admit their financial difficulties.
Nevertheless, PPMs have proved popular with consumers and now about 15 per cent of consumers pay by
this means. Government and the Regulator did explore the idea of withdrawing PPMs because of the
difficulty of preventing PPM consumers being disadvantaged, but they are popular with consumers and
their withdrawal would not be politically acceptable. Consumers may well be aware that they are paying a
higher price for their power, but, in the same way as pre-payment mobile phones are popular despite high
call charges, they value the extra control over tight household budgets that the PPM gives them.

4.2 PPMs in a competitive market

The pros and cons of PPMs were reasonably balanced as long as the residential market was a monopoly.
Consumers were able to control their expenditure on electricity and, if they did have to cut themselves off,
they could reconnect themselves easily and at no charge. PPM consumers were not charged significantly
more for their power than other consumers. However, the opening of the residential market to competition
has swung the balance against PPMs. The differential between PPM and other tariffs cannot be capped
because residential prices are no longer regulated. Retail supply companies claim the cap did not reflect
the extent of the extra costs incurred by PPM consumers and they are looking to increase the differential.
Without the protection of the cap, PPM consumers are likely to do badly.
It is difficult to assess independently whether tariffs accurately reflect the costs incurred. However,
increasing the differential does serve other strategic purposes for retail supply companies. Those paying
by PPM are clearly unlikely to be able to afford the range of other services retail electricity suppliers now
offer. Companies looking to win new consumers have an easy way to identify the class of consumer least
worth targeting. It will be difficult for the Regulator to identify companies that are not marketing, for
example by telephone or by door-to-door sales staff, to PPM consumers.
The impact on prices is already apparent. There are three ways to pay for electricity in Britain: by
monthly Direct Debit; quarterly in arrears (the most common method); and by PPM. For a retail supplier,
the most attractive consumers are those that pay by DD. There are now seven main competing suppliers in
Britain and all the suppliers offer marginally lower prices to DD and quarterly consumers than the
incumbent suppliers do in their home territory. By contrast, the incumbent supplier is normally the
cheapest supplier for PPM consumers and, in some cases, the competing companies’ prices are much
higher than those of the incumbent.
A consumer paying quarterly could probably reduce their electricity bill by about 12 per cent if they
switched to the cheapest supplier and paid by DD. A PPM consumer could not make any savings by
switching and the price they pay would be about 20 per cent more than that paid by a DD consumer.

5. The impact of structural changes

The British electricity industry has undergone a number of structural changes in the past three years that
are likely to have a significant impact, generally adverse, on consumers. The first change was to split the
regional companies into two separate entities. One part was the monopoly distribution business and the
other was the competitive electricity retail supply industry. The two parts of the business could still be
under the same ownership, but they had to be entirely separately run. In practice, the two businesses have
little in common: one involves the buying and marketing of a commodity and the other involves the
maintenance of an infrastructure. As a result, ownership of the two parts of the business is now splitting.
In competition policy terms this split made good sense as it prevented companies protecting their home
market by cross-subsidising its retail business from its monopoly distribution business. However, it left
retail businesses as very weak. A typical household electricity bill is $300 per year and the retailer’s share
of this is about $30. So the annual profit per small consumer is less than $10. Given that to acquire a

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consumer by advertising etc might cost $100, the business is probably too risky to survive as a stand-
alone business.
The natural partner to a retail business if the company that owns the local distribution network is not
allowed to sell electricity is a generating company: so-called vertical integration. For a generation
company, this reduces the risk associated with their generation assets. Instead of selling electricity into a
highly price-sensitive wholesale market, they can effectively sell direct to final consumers. Typically
large consumers have contracts for a year, while most small consumers are unlikely to move at all. The
other approach is for electricity retail companies to sell other household services, such as gas, telecoms,
financial services, road-side breakdown recovery, appliance servicing and cable TV: so-called horizontal
integration.
In Britain, both trends are occurring. The 14 regional retail businesses have now all been bought by six
generation companies. All the retail companies offer other services, invariably gas and usually telecoms.
While vertical and horizontal integration make good sense to the companies, they are detrimental to
competition. Instead of generators having to compete every 30 minutes to sell their electricity, as was the
original vision for Britain, generators effectively generate for their own consumers, leaving the wholesale
electricity market largely redundant.
The offering of multiple services not only increases the income the company receives per consumers, it
also gives the opportunity to obscure prices. Consumers generally believe that buying a ‘package’ of
services will be cheaper than buying them individually, but this is not backed up by experience.
Companies offer a cheap ‘loss-leader’ service and make up the losses from the other services. PPMs make
it easy for retail companies to identify poor consumers who are unlikely to have the money to buy a range
of other household services.
The other important trend is the concentration of the electricity industry throughout Europe into the hands
of just a few companies. Three strong companies already look set to dominate Europe: EDF (France), and
E.ON and RWE of Germany. These companies already own three out of six of the dominant integrated
generation/retail supply companies in Britain. An additional small number of regional companies, for
example, Endesa in Southern Europe, Vattenfall in Northern Europe and perhaps one of the Scottish
companies in Britain are also likely to gain a strong position. The likely result is that electricity markets in
Britain and the rest of Europe will be dominated by three or four international companies with little
incentive to compete hard against each other.

6. Conclusions
In terms of prices and system reliability, the reforms in Britain appear to have been a success. Closer
examination of the reasons for the reduction in prices suggests that the main reasons were not
improvements in efficiency caused by the operation of markets and the tough regulation. The main factors
were: reductions of 30-40 per cent in fossil fuel prices; temporary price reductions due to the effective
write off of much of the pre-privatisation asset base; and a shift in nuclear liabilities away from the
current generation to future generations.
The introduction of retail competition for large consumers allowed them to negotiate better prices, but it
seems that much if not all of the price reduction was paid for by small consumers. The extension of retail
competition to small consumers seems to have made the problem worse and has also given electricity
companies an incentive to discriminate against poor consumers that did not exist while retail supply was a
monopoly business.

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Table British Electricity Industry Structure – 1990 and 2002
1990 2002
Generation (Capacity GW)
National Power 30 British Energy (heavy losses) 11.6
Powergen 20 *Innogy (RWE) 8.0
Nuclear Electric 8 *Powergen (E.ON) 7.4
*Scottish Power (merger with S&S?) 5.0
*EDF 5.0
AES (kept solvent by junk bonds) 4.8
AEP (2GW for sale) 4.0
*Scottish & Southern 3.8
*TXU (1.2GW mothballed) 3.0
BNFL (huge losses) 2.7
Edison Mission 2.4
*British Gas 1.5
I’national Power (.5GW mothballed) 1.5

Retail supply
1990 2002
1. London
2. SWEB
3. Seeboard *1. EDF
3. Eastern
4. Norweb *2. TXU
5. South Scotland (Scottish Power)
6. Manweb *3. Scottish Power
7. North Scotland
8. SWALEC
9. Southern Electric *4 Scottish & Southern
10. Yorkshire
11. Midlands
12. Northern *5. Innogy (RWE)
14. East Midlands *6. Powergen (E.ON)

* Companies with generation and retail supply