The British model is the way forward now for Brussels

One area where the UK has led the world is in the reform of its energy markets. In 1985 both gas and electricity were supplied by inefficient incumbent state-owned monopolists. Today the UK has the world’s most successful retail competition with competitive gas and electricity supply and efficient privately-run companies.

UK energy markets continue to be the example which many other countries aspire to follow. Successive European Energy Directives, including the key ones in 2003 (2003/54/EC on electricity and 2003/55/EC on gas) have promoted a reform agenda which has drawn heavily on UK experience. In this short article I want to suggest what the key elements behind a successful energy market reform are and what the EU still needs to do to deliver the same sort of reform success as that experienced in the UK.

Reform of energy markets was not achieved overnight in the UK (contrasts still remain between the markets in England and Wales, and those in Scotland and Northern Ireland). British Gas was privatised as a private monopoly in 1986 and competition proceeded relatively slowly until its demerger into the gas supply company, Centrica, and the pipe infrastructure and gas production company, BG.

In 2000 BG itself demerged with the creation of Lattice (the pipe infrastructure company) which is now part of National Grid. Electricity reform occurred later, learnt from the mistake of the monopoly privatisation of gas. Beginning in 1990, with the creation of a wholesale power pool in England and Wales to replace the Central Electricity Generating Board (CEGB) and the privatisation of the regional electricity companies, the UK privatised all electricity assets but the oldest nuclear power plants.

By 2001 there was a very competitive wholesale power market and by 2006 almost half of residential electricity and gas customers have switched from their former incumbent supplier. The consequences of this reform have been large increases in productivity at every stage of the electricity and gas supply chain, which have (eventually) been passed on to consumers in the form of lower prices, increased investment and improved asset quality and a market which seems flexible enough to respond to supply and demand side pressures (such as the recent problems with the Rough gas storage facility).

The key lessons from the UK reform are relatively few in number. First, unbundling of monopoly transmission networks from production and retailing into a separately owned entity (‘ownership unbundling’) is essential for price transparency and for competition. Indeed, in Scotland, where ownership unbundling did not occur, prices and costs did not fall as rapidly as in England and Wales. Gas competition was inhibited by a lack of this in the decade following gas privatisation, electricity competition benefited immediately from the non-discriminatory access which a separate National Grid company provided, particularly for new entrants to generation.

Second, competitive wholesale markets with minimal entry conditions are important. Despite its flaws the England and Wales power pool did encourage new entry and over time the reduction in concentration in electricity generation brought about by active regulatory intervention did promote price reductions.

Third, sector-specific regulatory agencies, Offer and Ofgas (now merged into Ofgem), consistently promoted the reduction of the market shares of the incumbents in the power pool and in gas supply and used their market abuse investigation powers and their place in the merger approval process strategically in order to achieve increases in competition.

Fourth, the regulatory agencies delivered substantial reductions in the regulated network charges via the RPI-X price-control system which contributed significantly to the overall reductions in prices.

Fifth, a sustained belief in competition has been essential in sustaining the ongoing nature of the reforms both in the wholesale market (where the Pool was replaced by NETA in 2001) and in the retail market where competition among residential consumers has taken time to get going but seems now to be delivering benefits.

Looking to Europe, commitment to energy market reform is much more patchy. The Nordic countries — Norway, Sweden, Finland and Denmark — have similarly competitive wholesale and retail markets in electricity (though not in gas), albeit with continuing significant public ownership. European electricity and gas liberalisation directives have had a substantial forcing effect among member states but much remains to be done.

The most recent directives from 2003 have established free entry in electricity generation and gas trading markets, regulated non-discriminatory access charges for transmission and distribution systems (including cross-border links) and mandated legal separation of network businesses from retail and production. They have also promoted the establishment of independent regulatory authorities in each member state and set a timetable for the opening up of markets to full retail competition (1 July 2007 in electricity and gas).

Germany was the last country to establish a national regulatory agency for energy (in mid-2005) and most countries seem on track to achieve, nominally at least, full retail competition by the due date.

However it is not nominal compliance with the directives, but the reality of a lack of actual competition in many European energy markets which is the issue.

In electricity, France is still dominated by EdF, Italy by Enel, Germany is under the control of four regionally powerful energy companies (E.ON, RWE, EnBW and Vattenfall Europe) and Spain is a duopoly (Endesa and Ibedrola).

In gas, the picture is worse with a single company still largely dominant in France (GdF), Germany (Ruhrgas), Italy (ENI), Spain (Gas Natural) and several other countries. Worse still governments have been actively promoting old-style industrial policy aimed at increasing the financial strength of domestic energy companies.

The most blatant example of this was the approval of the 2002 E.ON-Ruhrgas merger, which was rejected by the German competition authority but received ministerial approval. This merger eliminated Ruhrgas as a potential competitor with the four major energy companies and was the equivalent of letting Centrica be taken over by E.ON-Powergen in the UK.

As half of all residential electricity customers who have switched in the UK have switched to Centrica this would have been a significant impairment of retail competition. A similarly worrying merger in Spain between Endesa and Gas Natural is undergoing legal approval at the moment.

The results of this dominance are continuing high costs, a lack of price responsiveness to supply and demand conditions, the potential for underinvestment and the continuing government intervention in the operation of energy markets.

At a time when the underlying cost of primary fuels is rising a lack of confidence in the ability of European energy companies to deliver will invite potentially further unwelcome government interference in the operation of energy markets which could result in substantially higher costs.

This is because governments will be tempted to make unnecessary investments on energy security grounds (the problem of the old CEGB) or will inadvertently engineer supply shortages by failing to allow final prices to rise to market-clearing levels (one of the major lessons from the Californian electricity crisis of 2000-2001).

The prescription for European energy markets, based on the UK experience, is relatively straightforward to explain, but difficult to implement.

First, ownership unbundling of gas and electricity transmission networks from the rest of the electricity and gas supply industry must be achieved. This is important for the promotion of national competition but also for encouraging the building of competition-enhancing international transmission links where these have a clear economic rationale.

Second, competitive wholesale markets must be created. This will require more generation plant sales in France and Italy but could be promoted more straightforwardly by the separation of transmission from generation in Germany. Further generation asset sales, or swops of assets to create more competitive portfolios are likely to be necessary.

In gas the situation is more critical. Monopolists or near monopolists control most European gas markets. Substantial effort to deconcentrate the control over long-term gas supply and production contracts will be required and possibly the deliberate creation of new gas companies (for example in France).

Third, regulatory agencies need to act more vigorously in the promotion of competition. They can do this by providing more information about the state of market competition and actively investigating market abuses. The signs are encouraging that the new German regulator will take a tough approach to competition, but the evidence from France, Spain and Italy is that their energy regulator lacks the authority to be a significant agent of change as was the case in the UK. Increased powers for the regulator and associated government support is required in these countries.

Fourth, regulatory agencies need to act more aggressively against monopoly profits in the pricing of electricity and gas networks. A lack of transparency in the cost allocation between the networks and the rest of the businesses is a problem. There is a wide and difficult to explain variation in both transmission and distribution charges across Europe.

This is problematic because some of the variation, particularly in Germany, may be explained by incumbents’ attempts to cross-subsidise competitive business segments from weakly-regulated (and therefore high) network charges. Squeezing network charges will encourage competition and ensure delivery of lower charges arising from competition to consumers.

Fifth, the striking thing about European energy markets is the fact that they represent national pre-disposition to competition so clearly. France, Italy and Spain retain a clear idea of national champions, Germany represents the idea of managed oligopoly, Nordic countries small-scale competition etc. Several countries are vying to retain their own independent companies as long as possible in order to gain influence over European energy markets. These attitudes need to change if substantial further progress is to be made.

The European Commission is to be congratulated in cajoling states into getting as far as they have with energy-market reform but much still needs to be done and the most important of it can only happen at the national level (or with national support for EU initiatives) — in France, Germany, Spain and Italy.

The recent EU Energy Sector Inquiry is a good start at clarifying the nature of the problems but it is unclear whether it will lead to the sorts of structural reform and break-up of national monopolies and oligopolies that would really promote energy market competition in the EU.

Dr Michael Pollitt is Acting Executive Director, ESRC Electricity Policy Research Group, Judge Business School, University of Cambridge.