53. Ofgem estimates that the 'Big 6' vertically integrated
companies hold sufficient generating capacity of their own to
cover their respective commitments to supply households and SMEs.
This business model has some advantages for consumers. By contracting
internally, the 'Big 6' are able to reduce their transaction costs
and protect domestic consumers from price volatility by cross-subsidising
their supply operations.
The Chief Executive of Scottish and Southern Energy (SSE) told
us: "At present [
] supply is loss-making. If it was
not for the fact that all of the six are vertically integrated,
prices to customers would already be higher than they are now".
Scottish Power confirmed this, while Centrica told us its margin
on the supply side of its business had averaged only 3.6% in the
last four years.
54. However, witnesses raised a number of questions
about the vertical integration model. First, in order to cross-subsidise
their supply businesses, the 'Big 6' firms must be making a reasonable
level of profit in their wholesale businesses. The National Right
to Fuel Campaign (NRFC) and the Government's Fuel Poverty Advisory
Group (FPAG) both cited a paper by Cornwall Energy Associates
that attempts to separate out the energy companies' input costs
from their profits.
It estimates that while fuel costs doubled between 2003 and 2006
to almost £9 billion, profits rose almost five-fold, from
£557 million to £2,635 million, most of which were
attributable to profits in electricity generation. The FPAG noted
that in 2003 profit levels were unsustainably low, given the level
of investment required in the sector. However, its Chairman also
acknowledged the difficulty in defining what a normal level of
profit might be, stating that: "Clearly the pendulum has
gone the other way for various reasons and they [the 'Big 6']
are now making very significant profits".
It notes too that while the EU ETS windfall will have accounted
for some this recent increase in profits, it only explains 15%
55. Drax Power argued that vertical integration could
lead to inefficiencies in plant operation, where firms use more
costly power sources to provide baseload generation, while more
efficient stations are used only to meet peak demand.
Another concern was the extent to which the vertically integrated
firms made information available to the market. Four of the 'Big
6' are part of larger European multinational firms. They therefore
do not report detailed separate financial accounts for their UK
operations. SSE also told us it did not break down its accounts
between its wholesale and retail businesses.
Centrica is the only 'Big 6' company that does report separate
accounts for its wholesale and retail businesses.
This kind of information is important for potential new entrants,
both to the wholesale and retail markets, as it provides transparency
about where profit-making opportunities lie.
56. While the 'Big 6' claim to be losing money
in domestic supply, there is evidence that they are earning increased
profits from their wholesale operations. We acknowledge that some
of these profits may be earmarked for investment in new capacity
rather than for distribution to shareholders, but we recommend
that Ofgem conducts further work to understand where profits are
being made within the energy supply chain. As part of this, we
also recommend that Ofgem investigates whether it can require
more detailed financial disclosure from the vertically integrated
companies on the performance of their wholesale and retail operations,
where they do not already provide this. Such information should
not deter new investment, but would inform potential new entrants
to the sectorboth generators and suppliers.
57. The biggest concern raised over vertical integration
was about the lack of liquidity in the wholesale electricity market.
Ofgem, Energywatch, the European Commission, the independent generators,
the large-scale consumers and the small suppliers all highlighted
this issue. Because
the 'Big 6' are able to supply most of their domestic and SME
customer base from their own generating capacity, there is much
less need for them to trade in the open market. They need only
do so to balance or hedge their positions.
As a result, the wholesale market has increasingly provided only
a balancing function for participants, focused primarily on short-term
trading. Total traded electricity is currently equivalent to 2-3
times physical delivery. Ofgem notes that this is low compared
to other commodities, for example gas trades at around 11 times
It is also in stark contrast to German and Dutch electricity markets,
where liquidity in recent years has been increasing.
There have been recent signs of greater liquidity, with screen-based
traded volumes up 30% in 2007/08 to £41 billion.
Nevertheless, Ofgem's Chief Executive went so far as to say that:
"The electricity market remains profoundly illiquid".
58. The lack of liquidity in the wholesale market
has various implications. Small electricity suppliers find it
difficult to get forward contracts that provide the volume and
shape to meet their customers' needs.
Welsh Power told us: "Quite simply we cannot buy what we
need to buy to deliver the power for our customers when we need
told us the 'Big 6' firms had proven very reluctant to provide
suitable offers for selling their generation, the implicit rationale
being: "We do not want to deal with you because all you are
going to do is compete against our supply business".
Independent generators are also reluctant to sell their electricity
in the smaller amounts required by the smaller suppliers. We heard
evidence that the credit worthiness of those smaller suppliers
was another obstacle for the generators, but we find this surprising
given the very small sums currently involved, with all the independent
suppliers put together accounting for only 1% of the market. Suppliers
are also less able to hedge out any risks in the wholesale market.
Furthermore, for both independent generators and suppliers, the
lack of liquidity creates greater volatility in the wholesale
price. With limited trading, there is very little price transparency.
This further discourages market participants, while those that
do trade are less able to determine whether the price they are
paying or receiving reflects the true market value. This risks
dulling price signals to any potential new entrants both in generation
59. The 'Big 6' companies did not agree that they
were responsible for the lack of liquidity in the wholesale market.
Rather they pointed to the demise of Enron and TXU, and the restructuring
of British Energy several years ago, as key factors in the decline
in the number of market participants.
There was disagreement over the possible solutions to the issue.
Both BizzEnergy and Welsh Power called for Ofgem to require the
'Big 6' generators to trade all their generation openly in the
The large industrial energy consumers said they would welcome
some fixed proportion of the generators' output being forced into
the open market.
However, British Energy noted that any such requirement on the
independent generators would increase the collateral they would
have to put up to trade in the market, and that this could act
as a barrier to new entrants in generation.
60. When we suggested to the 'Big 6' the proposal
of selling a proportion of their electricity in the open market,
they told us they already did this.
However, the fact that they trade and hedge an equivalent or greater
amount of electricity than they actually produce is different
to saying that their generating capacity is available to other
parties in the forward market. It is worth noting that EDF Energy
subsequently retracted its oral evidence that the company traded
all its electricity through the wholesale market, stating instead
that it traded "the equivalent of all [the] electricity
we generate" for balancing and hedging purposes.
We note Centrica argued that the vertically integrated firms would
still need to buy back most of their power from the market. The
additional transaction costs of this would inevitably be passed
back to the consumer.
61. E.ON UK did acknowledge that "the trading
market structure can be improved".
To this end, the "Market Design Project" was initiated
in 2006 by a number of industry players to help stimulate greater
forward market liquidity. However, it has made limited progress
to date, and is not expected to make significant advances until
at least 2009. Although this project, aimed at "capturing
all, or a significant majority of trades" is welcome, Cornwall
Energy Associates recently stated that "the bottom line is
that an important industry project kicked off three years ago
62. We also discussed the impact that trading rules
can have on the market, particularly in relation to the so-called
"cash out" arrangements intended to keep the supply
and demand of electricity to the market in balance at the time
of delivery. We are inclined to agree that these well-intentioned
rules could deter entry by smaller generators and suppliers as
they currently work. Ofgem is at present examining this issue
separately. Given its highly technical nature we make no recommendation
on it in this Report, but we look forward to Ofgem's conclusions
on this important issue.
63. The wholesale electricity market suffers from
a severe lack of liquidity, which contributes to price volatility
and poor price transparency. This, in turn, dulls market signals
for potential investors in new capacity, outside of the 'Big 6'.
It also reduces the ability of new energy retailers to compete
in the market. As Ofgem has already identified the issue as a
serious problem, and in the absence of tangible progress on the
Market Design Project, its market probe should propose a solution.
As a starting point, and in addition to any increase in transparency
that can be achieved as a result of our earlier recommendation,
the regulator should conduct a detailed analysis of the risks
and benefits of requiring the 'Big 6' firms to trade a proportion
of their electricity openly in the forward market. We acknowledge
that the regulator must take account of the need to balance the
effects that greater regulatory risk might have on the investment
decisions of incumbent companies. In principle, however, creating
a better functioning wholesale market should facilitate new entry
both in supply and generation.
76 Ev 391, para 16 (Good Energy) Back
Ev 445, para 39 (Ofgem) and Q 909 (European Commission) Back
Ev 445, para 39 (Ofgem) Back
Qq 790 (Scottish Power) and 792 (Scottish and Southern Energy);
Ev 213 (EDF Energy) Back
Q 795 (Scottish Power) Back
The Times, Difficulties elsewhere in power industry boost Drax's
image, 1 July 2008 Back
Ev 195 (Centrica) Back
Ev 449, para 54 (Ofgem); See paragraph 20 for an explanation of
the HHI Back
Ev 449, para 55 (Ofgem) Back
Ev 205, para 7 (Drax Power) Back
Qq 191 (Energywatch) and 401 (International Power); Ev 208, para
12 (Drax Power) Back
Q 568 (Ofgem) Back
Ev 584 (Ofgem) Back
BERR, Table of potential new conventional electricity generating
plants in Great Britain, November 2007 Back
National Grid, GB Seven Year Statement, May 2008 Back
Ev 584 (Ofgem) Back
Ev 453, para 71 (Ofgem) Back
Ev 453, para 69 (Ofgem) and Ev 186, para 2.15 (Centrica) Back
Ev 205, para 12 (Drax Power) Back
Q 393 (International Power); Ev 213 (EDF Energy) Back
Q 361 (British Energy); Ev 553 (Welsh Power) Back
Q 424 (Drax Power) Back
Q 61 (Minister for Energy) Back
Ev 450, para 57 (Ofgem) Back
Ev 450, para 56 (Ofgem), Ev 186, para 2.13 (Centrica), Ev 213
(EDF Energy) and Ev 562 (Wright and Rutledge) Back
Q 785 (Scottish and Southern Energy) Back
Q 750 (Centrica); Ev 496, para 2 (Scottish Power) Back
Ev 426 (National Right to Fuel Campaign) and Ev 378 (Fuel Poverty
Advisory Group) Back
Q 518 (Fuel Poverty Advisory Group) Back
Ev 380, para 11 (Fuel Poverty Advisory Group) Back
Q 385 (Drax Power) Back
Q 783 (Scottish and Southern Energy) Back
Ev 189, para 6.4 (Centrica) Back
Qq 329 (Major Energy Users' Council) and 907 (European Commission);
Ev 274, para 36 (Energywatch), Ev 159, para 19 (BizzEnergy), Ev
452, para 67 (Ofgem), Ev 205, para 9 (Drax Power), Ev 243 (Energy
Information Centre), Ev 234 (Electricity4Business), Ev 553 (Welsh
Power), Ev 172 (British Energy) and Ev 248 (Energy Intensive Users'
For example, EDF Energy told us: "We trade to source electricity
for our larger industrial and commercial customers, to hedge our
generating position, balance and 'shape' the mismatch between
the electricity we generate and our customer demand, and to adjust
for volume changes arising from events such as abnormal weather".
Ev 233 (EDF Energy) Back
Ev 467, para 16 (Ofgem) Back
Ev 313, para 3.3.1 (Energywatch) and Ev 553 (Welsh Power) Back
Ev 373, para 2 (E.ON UK) Back
Q 549 (Ofgem); Ev 537 (University of Greenwich) Back
Ev 274, para 37 (Energywatch) and Ev 537 (University of Greenwich) Back
Q 703 (Welsh Power) Back
Q 713 (BizzEnergy) Back
Ev 159, para 20 (BizzEnergy) Back
Q 568 (Ofgem); Ev 510 (University of East Anglia) Back
Qq 779 (Scottish and Southern Energy and Centrica) and 833 (EDF
Q 845 (Npower); Ev 213 (EDF Energy) Back
Ev 160, para 35 (BizzEnergy) and Ev 553 (Welsh Power) Back
Qq 328 (Energy Intensive Users' Group), 329 (Major Energy Users'
Council) and 333 (Chemical Industries Association/INEOS ChlorVinyls) Back
Q 362 (British Energy) Back
Qq 788 (Scottish and Southern Energy and Scottish Power), 844
(EDF Energy), 845 (Npower) and 852 (E.ON UK) Back
Ev 233 (EDF Energy) Back
Q 779 (Centrica) Back
Ev 374, para 6 (E.ON UK) Back
Ev 373 (E.ON UK) Back