What future for vertically integrated energy companies?


What future for vertically integrated energy companies?


Dieter Helm[1]

4th September 2014




The Big 6 British energy companies are under sustained attack from politicians and the media, and the Competition and Markets Authority (CMA) inquiry is being urged to consider whether they should be broken up. The Secretary of State, Ed Davey, has openly called for consideration of a break up of Centrica.


Unsurprisingly the companies have been putting up a robust defense of their conduct, and have argued that the vertical structures are in the interests of customers. In particular, it is claimed that they have the ability to put together contract portfolios to protect customers from volatile prices and that their size helps to facilitate investment.


These arguments matter, but they are not the only ones – or indeed necessarily the most important. Whilst politicians, regulators, the CMA and the companies debate these issues, the ground under their feet is shifting. The cost structures that ultimately determine the optimal business structures are being changed by fundamental and disruptive new and emerging technologies. The future of vertical integration does not depend solely on the arguments that justify the past and current structures. This short paper will briefly look at the conventional arguments before turning to the new contexts.


Prices and price volatility and vertical integration


Lets start with the first conventional argument: prices and price volatility are lower as a result of vertical integration. In a competitive market, prices follow costs. The facts are pretty clear: coal prices have gone down a lot in recent years, and recently gas prices have been falling to. In other words, the average fuel cost (coal) has gone down a lot, and the marginal (gas) price has fallen too. Customers have been “protected” from these falling input costs, by price increases earlier in the year, and then no price reductions. They are paying a higher price level, but are saved from the volatility of falling prices.


The companies have portfolios of contracts. They do not just buy spot. But how does their vertical integration help? If everyone buys in the wholesale market, all face the same costs and all have opportunities to hedge price risk. In a competitive market, some get it right and some get it wrong. The only extra thing that vertical integration brings is the ability to internalize, by selling own-generated electricity to its own customers. But this, several of the Big 6 argue, is a minor part of the market, and has been reduced as regulators have pushed for more auctioning of power to ensure liquidity and transparency in the market. The very physical hedging from own-generation portfolios is being deliberately limited by regulators.


The other advantage might be from size and scale – by the ability to buy in bulk. Yet the matching of customer demand and generation supply does not obviously lend itself to this argument. There might be economies of scale in customer metering, billing and other retail services, but bulk electricity does not seem to have this characteristic.


Whatever the economics of these features of vertical integration, there are at least facts and numbers for the CMA to work on. The CMA should be able to either lay to rest or substantiate the suspicion this is an example of smoothing prices to a level above the competitive ones. It is ultimately an empirical issue, and the CMA has the skills and capabilities to sort it out.


The investment argument


The second conventional argument made by the companies in defense of vertical integration is about the ability of large vertically integrated companies to invest. In their support, it has been claimed that the Big 6 have and are investing, and that this serves Britain well and will keep the lights on. At first glance this looks like firmer territory, but it is as well to take a look at the evidence.


The British electricity market is dominated by the Big 6. It is a market that is predicted to have a precarious capacity margin in 2015/16 of perhaps as little as 2%. This is not a comfortable margin – indeed the failure of a couple of AGR nuclear reactors and a cold, high pressure and hence low wind, winter spell could be nasty. So worrying is this possibility that the System Operator, National Grid, is employing special mechanisms to make mothballed plant available and paying companies to switch off at its command.


This is not a market that is investing in an optimal way. There is little evidence that any of the Big 6 is now investing much in new power generation, except EDF’s push for a new PWR at Hinkley. Several are selling off their power stations, and some have such precarious balance sheets that they are in no position to do much investment at all.


The reasons are various, but two stand out: the fact that the market design which was ushered in with NETA over a decade ago does not provide incentives to provide for a capacity margin for the system as a whole; and the fact that the host of government interventions have raised the cost of capital by massively increasing political and regulatory risk. Taking the two together, the regulators (with NETA) and the government have made it very hard to justify new power station investments. This cannot be all the companies’ fault, try as politicians might to pass the blame.


Investment now is driven almost entirely by the government. Almost all new generation comes with either a FiT or a capacity contract. The government is effectively a central buyer, replicating many of the features of the CEGB. It is therefore a bit rich of the government to blame the companies for not investing except at its instructions. But the fact is that having made the market un-investable without government-backed contracts, the Big 6 are no longer necessarily part of the solution, and vertical integration brings no obvious benefits in a contract auction. Anyone can bid for the contracts, which customers have to pay for. It may not be fair to create risk and uncertainty, but the fact remains that governments are not so beholden to those it thinks it no longer needs. RWE and E.ON have discovered this painful truth in Germany already, and all the Big 6 are discovering it here.


The coming of generator-only companies


In a capacity and FiTs world, there is no obvious need to be vertically integrated. Indeed it may turn out to be a positive disadvantage. The vertically integrated companies have to have regard to their existing assets, and the relation to their customer base. The generator-only company has no such worries. It has no customers, and it does not need them. All it needs is a capacity or FiT contract, and then it can bank this against its new assets, and indeed tap the securitization market. It is very much like a regulated asset, with the contracts acting as guarantees for what is in effect a contract (re regulated) asset base – a RAB.


Already wind farm investors have worked this out. New companies have made a major business out of this. The Big 6 have got into this game too, securitizing completed wind farms. The new companies come with relatively clean balance sheets, and carry none of the debt liabilities that arose after the great M&A activities that created and enlarged the Big 6. 


The future of supply


There is no reason to think that this trend to generation-only businesses is going to stop anytime soon. Indeed it is being further encouraged by the government‘s and regulators’ multiple interventions into supply. Why would any generator want to own a supply business? The competitive market, such as it was, has been gradually re-regulated. Companies are now forced into a maximum of four tariffs, and the scale of other obligations has radically changed the nature of the business.


If the benefits of vertical integration in addressing volatility are limited, and if investment is now state-driven, the final argument is that generators are in some sense better at supply. In other words, generation portfolios and the associated skills make them better and more cost-effective suppliers.


This has long been a difficult argument to swallow. It is true that there are economies of scale in supply, but that is an advantage to scale in supply, not helped by the fact that the supplier is also a generator. Generation is not an activity that breeds marketing and customer service skills. Rather supply needs a different type of manager and workforce.


Supply is largely an asset-less business, whereas generation is asset heavy and capital intensive. The former needs working capital and works on a margin; the latter needs a balance sheet and works on a rate of return on capital employed. There is no obvious advantage in merging these two very different activities within the same financial structures.


New disruptive technologies


These various competition and business arguments are all played out against the existing technologies. New technologies have the capacity to be really disruptive and radically change the business models of the companies. They come in many shapes and forms. The existing vertical structures are the product of at least three main bits of cost architecture: marginal cost electricity pricing; the absence of bulk storage; and a passive demand side.


Together these three features dictate that the electricity system needs a System Operator. There has to be instant matching of supply and demand (and therefore a merit order) and a capacity margin since demand side participation in the market is minimal.


All this is about to change. There are new generation technologies, notably next generation solar, which are overwhelming zero marginal cost. Zero cost technologies undermine the role and rationale of the wholesale market. It cannot order dispatch in a merit order, it does not signal when to invest, and it is not the driver for the reasonable rates of return on existing assets. It requires a capacity market and fixed priced contracts instead.


Large-scale storage would change the game, away from the need for a centralized grid driven by ever-larger power stations. At the micro level, wind farms would no longer have so significance an intermittency problem. Electric cars would become a large-scale disaggregated storage system.


Perhaps most radical of all will be the application of information technology to households (and companies). The future of supply is a broadband enabled smart household, with active management of energy systems and appliances, GPS enabled apps to drive the relationship between the householder and the house equipment and heating, and real time data management.


The impacts of IT are only beginning to be recognized. But one thing is obvious: there is no reason to think that the household energy management and supply will be best driven by the existing vertically energy companies. The sorts of skill sets, investment models, the links to cars and mobility, the broadband kit and services are not ones that fit naturally with companies with a history of running and building big power stations.


The beginnings of major restructuring


In many respects the CMA inquiry and the arguments that the Big 6 have mounted in their defense are a side-show. The historical case for vertical integration has been a good one, and for the best part of a century it has arguably served us well. But the ground is being cut out from under it – the government with its FiTs and capacity contracts, and regulators with their interventions in supply are parts of the reason. It is not surprising that the Big 6 feel aggrieved, and this is not helped by the scapegoating by both politicians and the media.


The structure of the industry is however not a static one, and history – and the fundamental cost structure – moves on. The right structure is one that reflects the underlying costs, the relationship between the risks in the market and the financial structures of the companies, and the managerial skill sets relevant to the underlying technologies.


One irony of the conventional arguments about vertical integration is that they may just turn out to be irrelevant. Smart companies might conclude that it is better to jump before they are pushed – the breaking up the vertical structures might be in the interest of their shareholders regardless of what the CMA recommends. On the optimistic side, the Big 6 mostly worked out they don’t need to be integrated into transmission and distribution as well as generation and supply. But history is not on the side of bold pro-active break ups. Companies do not like to downsize and they reinvent themselves only when faced with massive challenges. It is a game being played out by the Big 4 supermarkets as they struggle to come to terms with the Aldi and Lidl models and the coming of on-line shopping. It remains to be seen whether in electricity they are pushed, or they jump – or perhaps they slowly wither.



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