Participating on “Newsnight” in a discussion on the subject of Energy prices Labour's Shadow Minister (no less) Caroline Flint said that what the Gas and electricity industries need, in the consumer interest, is more competition. This revealed a staggering lack of knowledge of how the Energy sector works and represents not just a curious ideological position for a Labour politician to take but a wholly erroneous confidence in free markets - in this area at least.
Energy is one of the commodities that we all need and use - and by all I mean not just individuals and families as consumers but industry, commerce and the public and private sectors generally and universally. Our transport sector relies on electricity for motive power (most if not all trains). We heat our homes, our factories, our hospitals etc. mostly with Gas. Virtually everything we do relies on Gas, or Electricity - or both. To say that Energy policy, and especially the provision of affordable and sufficient supplies of Gas and Electricity across the Nation, is crucial to our well-being should not really need saying. It is a statement if the obvious.
So if Energy at a Macro level is one of the key areas of Britain's resource management what does this mean for public policy making? Strategically it is Government's responsibility to assure our Energy future - and to do this in the national interest economically, environmentally, socially and reliably for the long term. This sounds complicated and highly political! It is certainly the latter - especially after the privatisation of the Gas and Electricity (generation and distribution) industries which began in the 1980s under Margaret Thatcher's Governments. But, I would argue, it need not be as complicated as some try to make it.
In this Blog let's take a look at Gas – broadly speaking the ground rules and modus operandi for Electricity are the same.
Natural Gas, which replaced manufactured (Town) Gas in the 1960s, is a finite resource produced from reservoirs underground in the world's hydrocarbon rich areas - including under the North Sea. It can be converted into some other useful commodities - but its principal value is as a primary energy resource in industry and the home (etc.) and as a fuel for many Power Stations where it is converted into Electricity. We are very substantially a Gas economy - a status that was achieved by constructing an extensive Gas distribution network over the past fifty years or so. There are few homes, except in the more remote rural areas, where Gas is not used for heating and cooking. The Gas infrastructure extends both to its transport and its consumption. Dedicated pipelines carry the Gas around the country to points of consumption - and these points of consumption are, with a few exceptions, wholly reliant on having continuous availability of Gas because there is no real alternative.
By definition there is not, and cannot ever realistically be, competitive physical distribution of Gas. There will only ever be one Gas network so any seller of Gas to end consumers has to use this network. As far as supply into the network is concerned there is a multitude of sources as Gas has, for years, been an internationally traded and distributed commodity. The principal source is the offshore production in the North Sea where, mainly in the British and Norwegian sectors, Gas is produced for UK consumption. The transfer prices at which the "upstream" producers of Gas (like Shell or BG) sell their product to the marketers is broadly based on European traded Gas prices. These prices will vary a little but in the main they are linked to Crude Oil prices. So if Oil prices rise or fall Gas prices move broadly in line – albeit with a time lag in some cases. As well as indigenous Gas production (augmented in time by shale Gas and other local resources) the UK needs to import Gas to cover the gap between local demand and local supply. Gas comes via pipeline from Europe and via ship as LNG (Liquefied National Gas). But whatever the source it all (or most of it) goes into the Gas distribution networks having been processed in privately operated plants to ensure that it meets the UK specification. The Gas distribution network is divided into sub networks, of which there are eight, each of which is owned and operated by a private company: National Grid, Northern Gas Networks, Scotia Gas Networks and Wales & West Utilities - each with a geographical monopoly.
This broad description of Gas supply shows not only that it is a strategic product whose price is subject to international factors of supply and demand but also that there is little significant scope for competition. Trading deals will be done on the margin and whilst the quantities involved are so large that a minor unit saving can be meaningful at a high level the differences at a consumer level will be negligible. Indeed there is a disconnect between price changes on the margin in the acquisition of Gas and changes in consumer prices. Consumer prices, over time, will track internationally traded Gas prices but the price that we pay in our homes is subject to other factors as well. The Gas marketing companies – British Gas (part of Centrica), Eon, EDF, Npower and the rest are primarily Gas retailers acquiring their product at wholesale prices from producers and selling it to end consumers. Their business plans are predicated on receiving income streams which cover their acquisition costs, their marketing expenses, and their operational costs – what they pay the network owners for distribution of Gas to homes (etc.) for example. There is little scope for cost differentiation and as a consequence there is little scope for consumer price differentiation. That is not to say that prices don’t vary because in a competitive market suppliers will always seek to increase their market share and aggressive tactical pricing is a tool that they all commonly use. But the key word here is “tactical” – none of the suppliers has a cost advantage that enables them
over time to be more price competitive. Their product costs, distribution costs, marketing costs and other costs are likely, over time, to be broadly the same. As will the fact that as private entities they must seek to provide similar financial returns to their owners/shareholders (dividend payments).
There is no underlying cost advantage that any of the Gas marketers has which makes them a preferable long term supplier for price reasons. For the consumer who gets a kick out of shopping around (and enjoys using the price comparison websites!) there may be some merit in frequently switching suppliers to take advantage of their tactical pricing offers. But over time the customers who stick to one supplier are unlikely to be significantly disadvantaged compared with the serial supplier switcher. And the idea that the consumer could benefit from the introduction of more players into the market is highly improbable.
All this brings us to one inescapable conclusion and that is that in a commodity sector like Gas or Electricity with structural reasons in place which offer little or no scope for achieving significant cost savings competition will always be either a chimera or will be restricted to very short term special offer type tactics which cannot endure for long. What would surely be in the consumer benefit would be to eliminate marketing costs completely as they are expenses incurred solely in the task of encouraging brand switching. Similarly there is no merit in the duplication of offices and administration that having a plethora of suppliers brings with it. Similarly why should a national asset like the monopoly gas distribution network be a generator of private sector profits? So what Labour should be arguing for is the renationalisation of Gas distribution and supply into one publicly owned monopoly – a “National Gas Service” (NGS) if you like. The NGS would be targeted with managing the long term provision of Gas to all UK consumers using its massive purchasing power to source Gas on world markets at the most competitive prices. Using its network efficiencies to drive down distribution costs. Using its economies of scale to eliminate unnecessary costs such as marketing. Using its generated margins solely to reinvest in the Gas industry rather than having them creamed off in dividend payments. The end result of such a revolution would be transparent pricing, security of supply and the good feeling that what is already largely a National asset (the distribution network) became much more explicitly so.
Paddy Briggs
October 2012
