The Privatisation of UK Electricity Industry

Dr Robert Hawley, Chairman of the Engineering Council (UK) and ex-CEO of British Energy plc, was the Foundation's guest speaker on 16 April 1999. This is a summary of his remarks

Robert Hawley
Robert Hawley

The theme was set for the privatisation of the UK electricity industry during the 1970s. The nationalised industries losses had escalated considerably under both Conservative and Labour Governments. There was a cost-plus contract culture between the nationalised industries themselves and between them and the privatised industries. Trade Unions had wreaked havoc by exploiting their monopoly collective bargaining position, resulting in gross overstaffing and poor labour efficiency with the ethos of working to rule. The industry maintained large engineering and research departments and insisted on being the overall project manager for any large construction project, resulting in overspecification and high capital cost of new equipment.

At that time the electricity industry consisted of the Central Electricity Generating Board (CEGB), who were responsible for generation and transmission in England and Wales, and 12 Area Boards responsible for distribution. In Scotland two companies, the South of Scotland Electricity Board and the North of Scotland Hydro Board, were responsible for generation, transmission and distribution as was the Northern Ireland Electricity Board in Northern Ireland.

To quote modern economists, the UK electricity supply industry was "a classic example of a cost-of-service regulated public utility, with excessive capital costs, overdependence on high-cost indigenous coal or nuclear power, a low rate of productivity growth, a low rate return on assets, in turn reflecting the inefficient balancing of interests - the coal miners, the industry itself, domestic voting consumers, large industrial consumers, the Department of Energy and the Treasury".

However, to be fair to the CEGB, their terms of reference in those days were to keep the lights on no matter what the cost.

The economic rationale for private sector investment was that there would be an immediate cash flow to Government helping Government to unlock value from existing assets for investment in other areas. In fact, by 1995, the Government had raised more than US$95 billion through privatisation. The process also leads to injection of new capital for expansion or modernisation programmes. It speeds up new construction to the benefit of local industries and national economies and brings the dynamics of the market to bear on customers' choice.

Coming from an engineering background, I would be the first to admit that the state electricity structure was engineering driven, with priority for security of supply and adequacy of the system rather than maximising returns and value for money.

This did have its advantages however. For example, during the all-out miners strike of 1973/4 the then little used oil and nuclear power stations were called into service to supplement the generation from coal stations, which had rapidly diminishing stocks of fuel. As a result, in spite of a so called three day working week and power interruptions, it was business as usual in the UK.

The UK electricity supply industry was "a classic example of a cost-of-service regulated public utility, with excessive capital costs, a low rate of productivity growth and a low rate of return on assets".

UK Privatisation

Looking at history, it is important to appreciate where electricity privatisation fitted into the grand scheme of things. The UK privatisation process can be split into three separate phases:

First, more competent management was imposed on government enterprises and management were given increased independence from political intervention. A financial control network was developed, with external financial targets and limits. The very first privatisation was of Amersham International (a radioactive isotope group). This led to the successful sale of British Telecom, which was the first privatisation of significant size. In the second phase, other major state owned monopoly businesses, were privatised such as British Airports Authority, British Gas and the successor generation companies to the CEGB, National Power and PowerGen. In the third phase, the rump of state owned enterprise and utilities were privatised - these however generally requiring substantial capital expenditure and restructuring. These included the water utilities, the coal industry, British Rail and the nuclear power Company British Energy.

The most relevant privatisation prior to that of the electricity industry was the gas industry in 1986. The lessons learnt from the privatisation of British Gas played an integral part in the restructuring of the CEGB. Faced as it was with the political timetable set by Margaret Thatcher, and a determined senior management wedded to the idea of privatisation as a single entity, the Conservative Government opted to privatise British Gas as one entity. This set it up as a cosy monopoly business, with no competitive framework for consumers to directly benefit from.

Although British Gas was initially seen as the main victor of the privatisation programme, its monopoly position has since been eroded by relentless regulatory intervention. The decline in British Gas's fortunes following the introduction of competition in the early l990s, raises the question of whether the company should have been broken up prior to privatisation or not.

In fact, last year, British Gas was split into two separately listed companies, BG and Centrica. Centrica is responsible for supplying gas throughout Britain, and BG comprises extensive global exploration and production activities as well as the gas pipeline and storage network.

After the privatisation of British Gas as a single entity, it was clear that separation of transmission, generation, distribution and supply was a requirement for the restructuring of the electricity supply industry if there was to be a more competitive environment than that of British Gas post-privatisation. And after strenuous arguments with the then Chairman of the CEGB, Government consultants demonstrated such a split was actually feasible.

As a prelude to privatisation, the electricity industry in England and Wales was radically reorganised on 31st March 1990.

The CEGB was split into four companies. The transmission system was vested in The National Grid Company. There were to be two generating companies, National Power and PowerGen, with National Power significantly larger, as it was to include the nuclear power stations. In November 1989, however, these were separated to form Nuclear Electric as the third company which remained under government control.

The 12 Area Boards were superseded by the 12 Regional Electricity Companies. They were given a licence to distribute and supply electricity within their own areas. It is important to mention that the licence to supply was limited to customers with a demand of less than one megawatt, the so-called franchise market. I will come back to this point later.

There were several key issues that arose after the initial privatisation of the electricity industries.

First, was the industry sold too cheaply? The Unions accused the Thatcher administration of "selling priceless national assets on the cheap". They supported this by quoting the level of over subscription of the public flotations - an average of 10 times oversubscribed for the electricity utilities. This overdemand also led to large share premia on the first day of trading.

However, people often forget that there is a very fine line between a successful flotation, with a high level of demand, and a disastrous flotation, with undersubscription for the issue. It must also be remembered that the nationalised industries tended to have very inadequate accounting systems and combined with a lack of similar companies to make comparisons with, it was extremely difficult to estimate the value of the businesses. Critics, with the benefit of hindsight, omit to recall just how risky the sale of large state owned businesses appeared at the time.

With National Power and Powergen successfully privatised, Nuclear Electric, still under Government control, had to compete with them in the market place in order to survive. And compete it did, improving efficiency, productivity and output from its stations to such an extent that in May 1995, the UK Government announced that it would privatise the more modern nuclear stations.

On 15th July 1996, British Energy was successfully floated.

Following privatisation, employee numbers fell dramatically in the industry. Many people are still critical of the level of redundancies that occurred as a result of privatisations. But a distinctive feature of nationalised industry was the colossal level of over-manning, with little management incentive to do anything about it, even if they could overcome union difficulties. After privatisation, reviews of production methods, coupled with reforms in the industrial relations legislation, enabled management to tackle long standing areas of inefficiency and waste.

Orders were placed for turnkey power stations (mainly combined cycle gas turbine stations as new European legislation has allowed gas to be burnt for the generation of electricity). This eliminated the need for large teams of engineers and project managers. IT eliminated the need for certain administrative and production roles and outsourcing of non-core competencies reduced the nominal headcount. Savings were passed through to shareholders and customers, albeit in the early days shareholders received more benefits than the customers.

There was an argument as to whether the electricity companies earned too much of the savings that privatisation unleashed. Critics point to studies suggesting that customers had paid more for their electricity than was necessary because of over generous price cap rules. To quote, "The huge level of windfall profits. . . make it clear that the customer has not, in fact, been protected under the formula".

However, everybody, including the regulators, underestimated the size of potential efficiency gains, which has allowed capable management teams to deliver considerable cost savings to customers. And by 1997 prices were 20% lower in real terms than they were pre-privatisation.

In addition, tax payers (shareholders and customers alike) benefited when the government imposed a large "windfall" tax on the utilities in 1997.

After privatisation, technical standards did not suffer. In fact they have been maintained or improved and guaranteed standards have been introduced. Overall performance has improved, and dis-connections are down by over 95% since privatisation. In fact, it would be fair to say that one of the keys to the success of the industry has been its adoption of customer focus as an integral business driver.

In the case of British Energy by 1997 it had become the world's most productive electricity generator producing 80% of the power it had the capacity to produce.

 

So how has the industry operated post privatisation ?

The structure of the industry was designed to encourage competition where feasible but to regulate prices where natural monopolies exist or where competition required time to emerge.

In order to balance electricity supply and demand, the UK government instituted a power pool to act as a clearinghouse between generation and wholesale consumers of electricity, (primarily the Regional Electricity Companies). All generators bid into the mandatory pool. All the Regional Electricity Companies are entitled to purchase their electricity from it, as are a growing number of other consumers. The pool operates as a spot market, with 48 half-hourly blocks per day. Each block is priced a day in advance. The generation bids are entered in the National Grid Company Goal program. Along with these bids are computed forecasts for the demand. From these inputs, the program derives the half-hourly marginal costs for the next day. The systems' manager ranks the bid from least to most expensive. The last unit needed to meet demand fixes the marketclearing price.

However, the Regulator claims that the current structure allows the big generators to manipulate the System Marginal Prices. Together they typically set prices for around 80% of the time, which they achieve by making enough of their capacity unavailable for generation. It is claimed that they can then set the price at whatever level they want.

So the Pool system is under review at the moment. Details have not yet been finalised, but there is expected to still be trading in half-hour slots, with a balancing market to iron out the physical imbalances.

Supply competition is a vital aspect of the system. As I have already mentioned, Regional Electricity Companies were initially allowed to keep their monopoly over supplies of electricity to customers with a demand of less than one megawatt. For the 4500 customers in the "Greater 1 megawatt" market the impact of competition was enormous as they were given the right to choose their supplier.

In April 1994 the free market was extended further, to include customers with a demand for lOOkW and above, which covers customers such as supermarkets, hospitals, small factories and offices. This market accounted for about 70% of all electricity sold in the UK, and has seen benefits for customers who are able to use their freedom of choice to negotiate individual, more favourable contracts to accommodate their specific needs.

The UK is completing the journey to full supply competition as we speak. From the middle of this year all UK consumers will have the right to choose their electricity supplier. Suppliers such as British Gas are competing with the Regional Electricity Companies leading to lower prices.

 

Consolidation of electricity industry

Since privatisation, the electricity industry in the UK has continued evolving and developing, with much takeover activity. American companies currently own 5 of the 12 Regional Electricity Companies; 3 of the Regional Electricity Companies have been bought by UK Generation companies; The French have just bought London Electricity; 2 of the Regional Electricity Companies have merged with their local water utilities.

Foreign ownership of privatised companies is not limited to the electricity companies. The rail privatisations and water have also attracted foreign investors.

PowerGen, National Power and the National Grid remain independent. A large number of other companies are now active in generation. PowerGen has taken over a Regional Electricity Company and become virtually integrated. National Grid has used its transmission system to set up a telecom company ENERGIS capitalised at GBP4.7 billion compared to National Grid's original capitalization of GBP3.5 billion. The water companies have moved into waste management.

The gas, electricity generating and distribution companies have all moved into international activities purchasing utilities offshore or entering into joint ventures for operations. Initially most of these proved disastrous, showing up the lack of project management in the fledgling companies but the situation is now improving as the companies have become more experienced.

All of the Regional Electricity Companies now have interests in generation and there has been a marked increase in the number of independent generation companies, who have built predominantly combined Cycle Gas Turbine and Combined heat and power plants. In 1990 there were 10 generating companies and 16 suppliers in England and Wales. Today, there are 32 generating companies and 34 suppliers. As mentioned earlier, the market share of PowerGen and National Power has decreased, but they remain in a dominant market position. However, the Regulator is now insisting they sell off a large proportion of their generating capacity to prevent price fixing and stimulate more competition.

So new horizons have been opened up by such commercial freedom and many companies are now moving into related businesses such as gas and telecommunications, both within the UK and overseas. This has led to both a "globalisation" of business and a move to what we call "convergence" - the creation of energy businesses rather than single fuel electricity companies. Electricity markets have been able to do this because of the deregulation of other utility markets in the UK such as gas and telecommunications.

All industries now have an international dimension and increasing internationalism requires a change in attitude - the electricity industry can no longer be organised in terms of national monopolies.

 

What of future privatisations?

In the UK, nearly all the state owned enterprises that constituted the nationalised sector in 1979 have been privatised. All that remains is either difficult to sell or largely unsellable - although it must be remembered that people said exactly the same things about many of the industries which were successfully privatised. The Post Office, whilst financially "doable" is nonetheless highly politically sensitive, and the Communications Union successfully lobbied against Michael Heseltine's privatisation proposals in 1994. The London Underground is introducing public/private partnerships, and is in desperate need of a capital injection. The National Air Traffic Service is soon to be privatised and may generate GBP500 million in sale proceeds.

Other options facing the Labour Government include the sale of state owned assets and land. The Ministry of Defence is a prime target - it holds more than 250,000 hectares of land along with many thousands of houses - as is the Forestry Commission, which is the largest landowner in the United Kingdom. Individual executive agencies of government, commonly known as Next Step agencies, might well be privatised. Several, including the Paymaster Agency and the Building Research establishment have already been privatised, and others including the Royal Mint and the Patent Offices are being looked at carefully.

Besides these, there are a number of substantial enterprises owned by local authorities, most notably the water and sewerage utilities in Scotland and several major regional airports.

So in summary, in the UK privatisation has provided lower prices and better quality service for the customer, reduction in government expenditure, and dynamic private companies to drive the economy, and even under a New Labour Government it seems there is more to come.

The above does not necessarily represent the views of the Foundation.

 by Robert Hawley