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Privatization of the UK Electricity

Free «Privatization of the UK Electricity» Essay Sample
 

Introduction

The British electricity supply industry was under the control of the UK government from 1948 to 1990. It consists of three prime sectors such as generation, transmission, and distribution, which are largely responsible for delivering electricity at nominal prices to the consumers, as well as maintaining the productivity and growth of this sector. Prior to restructuring electricity sector, CEGB was responsible for the generation and transmission, while 12 private electricity companies carried the distribution and supply operations all over the England. In this period, the Central Electricity Generating Board was an example of excessive capital costs, low return on assets, low productivity growth, highly dependent on nuclear power and high-cost indigenous coal. The initial years of privatisation noticed rise in actual prices, costs and reduced profits. However, with the introduction of regulatory mechanisms, there have been substantial cost reductions, which resulted in higher profits.

In 1990, the privatisation caused replacement of 12 area boards with the 12 RECs (Regional Electricity Companies) authorising the National Grid Company to be solely responsible for transmission system. Distribution and supply systems were not aligned to a large extent because a regional company could supply electricity outside its allocated region on a specified payment for distribution over another regional company’s network. What were overall costs and benefits received from privatisation? The question is significant not only because the CEGB contributed a key share to the economic development, around 1 percent of GDP, but also its restructuring was an important step for Thatcher’s government. This experiment proved to be highly successful and provided a model for electricity reforms in the whole world.

The current paper examines the economic impacts of privatisation on formerly government-owned electricity companies and the success of restructuring while providing benefits to the consumers. Moreover, the paper assesses financial performance, price caps, labour and productivity growth as well as social cost-benefit analysis. Current analysis will help to arrive at conclusion who lost, who gained, and the corresponding amount by comparing the results of pre and post era of privatisation.

The UK Electricity Reforms and Their Influence

The privatisation and restructuring of the electricity sector in the United Kingdom in 1990 reflected that higher productivity can be achieved by replacing state-owned electricity sector with privately owned, controlled companies. In the UK, the CEGB was transformed into three generating organisations and the National Grid Company, hence generating sector was separated from transmission activity. With the creation of 12 regional electricity companies, the Electricity Pool was established. Eligible consumers whose requirement exceeded 1.5 MW of electricity had liberty to purchase power from the open wholesale market (Bogorad & Penn 2001).While Scotland decided to retain the two vertically incorporated regional companies in order to conduct both businesses in the wholesale market, whose prices offered a standard measure for regulatory purposes. However, Northern Ireland preferred to isolate from the Republic of Ireland by selecting the Single Buyer System. Transmission and Supply activities were retained by a regional company, while four prime generating plants were sold to private buyers who entered Power Purchase Contracts with Northern Ireland Electric Board. Newbery (2000) have conducted social cost-benefit analyses of three different models implemented by the UK government while restructuring the electricity that produced striking and plausible outcomes. The privatisation of the CEGB introduced competitive price bidding for each power generating company. All generating stations impressively increased productivity and cut down costs. The first five years audit of these companies showed that the social benefits reduced costs nearly by five per cent, which is equivalent to a 90% return on the revenue growth (Domah & Pollitt 2001).

Moreover, these benefits increased profits with the decline in costs and prices which continued to be aggressively high until regulatory reform forced divestment of generating capacity. Almost after eight years, the dominant duopoly created a relative scattered industry. The RECs operated efficient gas turbines, bought divested plant, and privatised the nuclear plants. Scotland projected a different picture. In 1990s, prices of electricity were 10% lower than in Ireland and England, but the lack of competitive pressure increased the decade stable prices nearly by 5 to 6%. The modest gains of privatisation were largely consumed by the restructuring costs, thus no net benefit could be delivered (Evans & Green 2005).

Northern Ireland demonstrated mixed results. The long-term power purchase contracts offered powerful incentives for improved plant capacity and reductions in cost. Therefore, the improved output could be three times higher than that of the CEGB. However, these contracts reserved the financial assets for the generating companies, and consumers received benefits from government subsidies and massive price reductions o the elements of cost to reduce the price gap between England and Northern Ireland. The lessons learnt from electricity privatisation are self-explanatory. Increased competitive pressure on generation is required to minimize costs.  This process demands separating generation from distribution and transmission. Whether these incentives will reach consumers largely depends upon the gravity of competition in the British Pool and the availability of open access to wholesale market (Ofgem 2000).

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Un-restructured electricity sector, even if privatised, deliver few incentives. Strict regulatory price controls and price caps are necessary in order to enhance efficiency in distribution and transmission sector. Results of efficiency gains and higher productivity during the first four years of the strict price regulation were satisfactory, and the consumers were satisfied with the privatisation and reduction in prices. The evidence showed that RECs had to work hard to convert efficiency gains into lower prices. They were also cautious to counteract further disinvestment in generation capacity if the consumers were to gain benefits from restructuring.  The distribution of electricity is a prime activity of the RECs and contributes the significant proportion of their net-profits and operating cash flow. In 1999, charges for supplying and distributing accounted approximately 14% and 33% of a customer’s electricity bill, and distribution renders a significant impact on the quality of supply to the consumers (Price 2001).

Analysing the effect of changes in ownership makes economic sense due to the significant impact of electricity distribution system rendered on final prices as well as the distribution of incentives and losses due to these changes. For making privatisation successful, the UK Government preferred to implement initial price controls over the distribution system for a period of five years, which enabled increase in distribution charges in real context. During initial controls, RECs improved their profits significantly, which became a subject of controversy, sinse it was clear that the initial price caps established by the UK government were ‘too’ favourable for the electricity companies. In August 1994, OFFER, after conducting the review, announced reductions nearly by 14% in final electricity prices to be effective from April 1995 (OFFER 1999).

It was a prime challenge for the UK government because from 1991 to 1994 the majority of consumers did not receive price advantage from the privatisation. Tariff consumers effectively benefited from the privatisation whereas the majority of consumers lost the interests of their special agreements. Only those consumers who had requirement of 1-5MW had received benefit because they avoided subsidy of British Coal. Moreover, prices for domestic electricity initially increased, as compared to the industrial prices, by nearly 5%, which was never expected from restructuring and privatisation. Newbery (2000) noticed that shareholders taxpayers were the major beneficiaries of the CEGB privatisation. However, they warned on applying this outcome to judge the entire privatisation until the distribution and supply systems are analysed.

Regulatory Mechanisms in the UK Electricity Sector

Privatisation and the implementation of high-powered control systems for transmission and distribution network have increased the productivity and quality of service in electricity distribution network of England. The implementation of incentive regulation systems for the independent functioning of transmission can also minimise costs of regulating congestion in the network and maintaining the efficiency in its systems. The privatisation has led to improvement of new generating capacity by largely replacing the current one in order to meet growing peak demand of the market. The retail distribution program in the UK has been largely successful, but it raises many doubts regarding the issue whether the incentives of extending retail distribution to domestic consumers was actually worth the costs. Undoubtedly, efficient distribution and transmission network regulatory mechanisms are necessary but they are often neglected components in the reformation process (Laurie 2001).

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It should be remembered that the reformation model includes the application and development of a well-structured regulatory mechanism to manage the transmission and distribution, which will be always subjected to the government regulation of costs, prices, service quality, and investment programs. These remaining regulated segments represent an important fraction of the total retail price paid by consumers. Moreover, the performance of the regulated components can render significant impacts on the execution of the competitive segments because the regulated segments offer the infrastructure platform to the competitive ones, for example, distribution and the transmission. The favourable consequences of restructuring and reformation are achieved due to the performance of the controlled and competitive segments in the electricity sector. Regulatory reforms, which focused on PBR mechanisms, were a prime feature of the privatisation program of the UK government. Moreover, the regulatory institutions that have evolved also reflect the standard of effective incentives and performance-based regulation (Domah & Pollitt 2001).

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Privatisation has engineered high-powered regulatory mechanisms leading to overall improvements in generation, transmission, supply, and distribution. The sectors facing the problems of outdated equipment, poor maintenance, as well as thefts electricity have experienced significant decline in losses with the introduction of incentive control mechanisms. This study shows that the high-powered control incentives created by British electricity market has lower operating costs as well as improve service quality and productivity (Green 2005).

Price Controls and Reviews

Each regional electricity company (REC) distribution business possesses an effective regional monopoly. Thus, for protecting consumers’ interests from the abuse of monopolistic power, a regional company is a subject to control of its prices through the price caps, and the service quality it should provide is strictly controlled. On the other hand, while supply businesses have been modified with the increase of competition, the control has lost its significance. In 1990, bulk consumers were free to choose the suppliers; medium users had liberty to switch suppliers from 1995 and all domestic users from 1998. The final price of electricity includes a number of components. While prices in supply, generation and transmission services decline with the Price Control Review, the distribution prices could not be reduced that resulted into consumer paying higher prices for electricity (Gilbert, Neuhoff & Newbery 2004).

Price regulation of the regional electricity companies’ supply systems restricted average prices to increase by no more than the rate of inflation during 1990 to 1995, and then UK government tightened the regulation to RPI 2 for the supply activity of all regional companies until March 1998. Further, in April 1998, revised regulations reduced prices to 12 percent, and a reduction of 3 percent occurred in 1999. Price control recommendations for 1998 and 1999 were respectively decided in 1997, setting an average decrease in prices by 6 percent in 1998, followed by a reduction of 3 percent in 1999 (OFFER 1997). Price regulations applied in 2000 to 2002 were set on the standard of domestic and economy consumers, with price reduction of 5.4 percent on the final prices.  It was anticipated that the regulations would no longer be required after this period due to the increased competition in supply business (Newbery 2006).

Henney (1997) stated that the increase in profits and prices, after privatisation, was a regulatory failure resulting from the negligence towards deciding price control on wires. Moreover, the UK government could not support the claims with evidence for potential productivity benefits at the time of privatisation. The first five years from 1990 to 1995 noticed large appreciation in the profitability of the regional electricity companies, leading to the increase in their share prices.

Such untimely windfall gains to stakeholders attracted the attention of the labour government, which imposed appropriate taxes on the profits of all REC’s (Henney1997).

Efficiency Gains and Productivity Measures in the UK Electric Regulation

After privatisation occurred in 1990, initial price caps were established because the UK government still owned the financial interests in the electricity sector. At this period, a misjudgement occurred regarding offering generosity to electricity companies for setting the prices. There was not precise information regarding potential efficiency saving within the electricity companies. However, in reestablishment of the prices, the only criterion was ensuring a rate of return on the capital to provide sufficient return to the stakeholders allowing the improvement in efficiency savings within the electricity companies. Somehow, the debates on price resetting have raised two questions. The first ne focused on how to calculate the capital base and what would constitute a potential rate of return. The second issue referred to appropriate cost saving, increased efficiency gains, and productivity. Since the price cap determines revenue growth and profitability, its level should be at the minimum costs achievable for the particular level of demand decided by the capital available. Hence, the prices would become viable if it utilized all efficiencies. The RPI –X method for calculating price cap concentrate on the costs reduction and, consequently, relies on achieved levels of increased productivity as well improvements of input prices. In other words, productivity improvement due to price caps has created enhanced efficiency in the UK electric supply regulation (Jamasb & Pollitt 2001).

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Conclusion

The British electric supply industry held a monopoly from 1948 to 1990. The CEGB controlled the generation and transmission of electricity all over the UK. Local Area Boards held the monopoly in the low voltage transmission and distribution business as well as control over the prices of electricity. This monopolistic infrastructure deterred entry of new companies and limited competition in the electric sector. The objective of privatisation had to reform the electricity sector so that the level of efficiency and labour productivity could be improved as well as reduction in costs was also possible. The government considered setting the price caps on RECs in order to generate higher revenues and profitability. This strategy was successful to a large extent as REC generated higher profits. However, on the other hand, the government generosity towards RECs created debates in the parliament as he shareholders received higher dividends from the face value of the shares held.

At the time of privatisation, four functional areas were separated. The distribution and transmission areas continued as monopolistic sectors, thus avoiding negative externalities and improving the functionality of the network. They were, however, subject to direct control of the UK government. The supply and generation sectors were competitive markets and without monopolies; hence, they were privatised and restructured during the reformation process. The reforms offered incentives and gains regarding the improved efficiency, quality of service, productivity, and attracted new investment. Moreover, reasonable electricity prices also enhanced the demand of electricity in the domestic and industrial sector. The whole sale electricity market (the British Pool) was not flexible. The Pool served as a spot market to balance the supply with the demand of electricity. Moreover, the Pool prices were condemned due to manipulation and undue hikes by oligopolistic electricity companies. The paper concludes that privatisation of the British electricity sector encouraged private ownership, and the revenue growth offered better incentives and gains to the companies and consumers than the benevolent kind of the government control. The competitive private sector demonstrated better results than monopolies of CEGB because the competition enabled efficiency gains through the price reductions, cost control and the quality of service in the privatised electricity sector.

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