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New model regulation in the electricity industry


Themes: Energy and environment

New model regulation in the electricity industryThe problem of monopolistic control in the UK electricity industry remains a factor today in spite of several decades of regulation by Ofgem, following privatisation in the 1980s. This would suggest that Ofgem has to focus as much on promoting competition as it ever did. However, a new report by Dr Michael Pollitt, Reader in Business Economics at Cambridge Judge Business School, argues differently, saying that the work of the regulator can be put to better use in focusing on two current issues; tackling the problem of climate change and protecting consumers suffering from ‘fuel poverty’. In order to adopt this new role, however, the UK needs a fresh model for the regulation of its electricity and gas industries.


The problem of monopolistic control in the UK electricity industry remains a factor today in spite of several decades of regulation by Ofgem, following privatisation in the 1980s. This would suggest that Ofgem has to focus as much on promoting competition as it ever did. However, a new report by Dr Michael Pollitt of Judge Business School argues differently. In his view, Ofgem has done its work in creating a more efficient and competitive electricity and to some extent gas market. Current problems with competition can be dealt with now by the likes of the Office of Fair Trading. But the work of the regulator can be put to better use in focusing on two current issues in which its influence is needed: tackling the problem of climate change and protecting consumers suffering from ‘fuel poverty’. In order to adopt this new role, however, the UK needs a fresh model for the regulation of its electricity and gas industries, argues Dr Pollitt.

Following Acts of Parliament in 1986 and 1989, the electricity and gas industries in the UK were opened up to greater competition. In this new environment, the Office of Gas and Electricity Markets (Ofgem) was charged with the duty to promote competition, underpinned by effective regulation in order to provide better value to the consumer.

According to Dr Pollitt, Ofgem successfully reduced the power of incumbent electricity (and gas) companies through regulation, which proved to be the most effective way to promote competition.

It also introduced price capping in electricity transmission and distribution networks, which helped to ensure that companies operated in the most efficient manner. This in turn enabled them to make savings, which could be passed on to the consumer. The changes in the 1990s brought about by regulation were significant. But Ofgem needs to change its focus to remain effective, argues Dr Pollitt. Deeply entrenched monopolistic power has been reduced, prices have converged and most inefficiencies have been weeded out.

Today, it is the external environment that is affecting the industry in new ways which impacts on the role of the regulator. Prices in the electricity distribution and transmission industry are being driven up by increases in capital expenditure. Increasing investment costs linked to the need to reduce carbon emissions, the requirement to renew and upgrade the existing network, and the rising levels of commodity prices (especially coal and gas) are all having a significant effect on operating costs.

The result is that the average household in Britain saw its electricity and gas bill go up from £370 to £881 between 2003 and 2006. This is in stark contrast to the period from 1995-2003 when prices dropped. Moreover, the number of vulnerable households, where more than 10 per cent of income is spent on fuel to maintain satisfactory levels of heating, rose from 1.2 million to 1.5 million in 2005.

Whilst the industry bears the cost pressures, the wider national debate, reinforced by the Stern Review of 2006, requires energy suppliers to reduce their carbon emissions dramatically.

Stern argues for spending one per cent of the UK’s GDP (around £13 billion) to achieve carbon emission reductions of at least 60 per cent on 1990 levels by 2050. Dr Pollitt points out that if the electricity industry reduces its emissions by 80 per cent it would bring down overall emissions by 20 per cent (one third of Stern’s target for 2050).

The Climate Change Bill (2007), driven by the newly created Office of Climate Change, and charged with keeping the country fixed on its long-term targets to reduce emissions has created a new challenge for the electricity industry. Regulation will need to take account of the processes it uses and not just the outcome argues Dr Pollitt.

In future, Dr Pollitt recommends that decisions about key investments (some of which might be intended to meet climate change targets) should be made by the buyers and sellers, with Ofgem acting as an auditor rather than as regulator. According to Dr Pollitt, there are already two successful models for this in existence. The first of these ‘negotiated settlements’ was developed in the United States where the risks of getting something wrong was shifted to the consumers and regulated companies leading to more informed trade-offs between quality and cost; The second came from the regulator of airports in Britain and the airport owners, known as ‘constructive engagement’. In this process, the British Airports Authority (BAA), which owns major airports in the country agreed to an incentive scheme for delivering new investment.

The new focus on the impact of rising prices on vulnerable customers combined with the need to take into account climate change obligations provides Ofgem with an important opportunity to have a significant impact on the key issues of our time. A tendering process for investments, for example, could help electricity companies find new savings to assist the most vulnerable consumers. It could also consider the big changes needed to encourage new forms of low carbon electricity generation, as well as new techniques such as heat networks, which capture the heat from natural or man-made sources and distribute it to homes. At the same time it needs to consider the importance of reducing demand for power to help reduce emissions, through the use of low energy bulbs for example.

The new model electricity regulator would promote, ‘economic efficiency in the delivery of energy’, using its powers to help the industry deal with its obligations towards vulnerable consumers and acting on climate change. So, whilst critics of the six electricity suppliers are clamouring for greater competitiveness in the sector, the regulator’s battleground has already moved on to new challenges where it can best focus its efforts, leaving current concerns to the likes of the Office of Fair Trading. The UK was at the forefront of electricity privatisation in the 1980s, influencing changes around the world. A renewed role focusing on climate change and vulnerable consumers might equally bring about a wider change in this industry across the world.

Further Reading

Pollitt, M.G. (2008) “The future of electricity (and gas) regulation.” Electricity Policy Research Group Working Papers, No.EPRG 0811. Cambridge: University of Cambridge. Available online at http://www.electricitypolicy.org.uk/pubs/wp/eprg0811.pdf