At a CEPR lunchtime meeting on 7 June, David Newbery presented his recent research on the privatization of electricity in Britain. Newbery is Professor of Economics and Director of the Department of Applied Economics at Cambridge University and a Research Fellow in CEPR's Applied Microeconomics and International Trade programmes. His remarks were based on his joint paper with Richard Green, `Competition in the British Electricity Spot Market', available as CEPR Discussion Paper No. 557, written as part of a project on `Privatisation and Re- regulation of the Network Utilities' funded by the UK Economic and Social Research Council (ESRC). The ESRC also provided funding for the meeting, as part of its support for the Centre's dissemination programme. The views expressed by Professor Newbery were his own, however, and not those of the ESRC nor of CEPR, which takes no institutional policy positions.

Newbery noted that the British electricity supply industry was extensively restructured in March 1990. Twelve regional distribution companies and two generating companies covering England and Wales had already been sold to the private sector. The distributors jointly own the National Grid Company (NGC), which in turn owns the transmission system and coordinates the generators. The two integrated Scottish utilities were to be privatized in June, leaving only the nuclear power stations in the public sector.

The new regulatory structure assumes that the efficiency of the generating companies will be ensured by competition alone. Newbery maintained that this could have been effective if the conventional power stations owned by the former Central Electricity Generating Board (CEGB) had been allocated to five equal-sized companies; but their actual division between two companies of unequal size will probably lead to high prices and large inefficiencies. The government's failure to appreciate the problems of selling the nuclear rump together with pressures on the Parliamentary timetable forced an inappropriate and uncompetitive structure on the industry, so substantial potential gains from providing free access to the National Grid may now be lost. By failing to exploit the potential of feasible competition, the government may be forced to avoid the high costs of duopoly through regulation.

Before privatization, the CEGB switched its power stations on (off) to meet increases (decreases) in demand in accordance with a `merit order', which ranked them from least to highest cost to ensure that given demand was met at least cost. Under the new system, National Power, PowerGen and the publicly owned Nuclear Electric submit price bids for every power station one day ahead of dispatch, and the NGC controller chooses the least-cost combination of stations scheduled to meet the anticipated demand. If each profit-maximizing company knows that by choosing higher bid prices it may lose some market share to its rival but will earn higher profits on the power it does sell, there will be a set of bid prices (for each generating set) for which these effects offset one another, Newbery argued. Each firm will submit this set of prices, which will depend on the other company's willingness to supply at a given price, as its supply function. PowerGen will respond to National Power's supply function by offering a function in which prices rise steeply above costs, but National Power needs this function to justify its own choice; and this self-sustaining pair of strategies forms an equilibrium if each company does the best it can, given the actions of the other.

Newbery noted a wide range of possible outcomes. If one company offers a low supply schedule, it will be in the other's interest to do likewise. If they both believe that the regulator will not intervene and that their bids will not attract much new entry, it is in their joint interest to bid high rather than low. For 1989-90 data on demand and costs, if the two firms bid as high as they can without collusion, prices will rise by 55% and output fall by 15%, they will make (current cost) operating profits of around £3.5 billion on a net asset base of £10 billion. The deadweight losses from reduced output and higher prices may amount to a staggering £650 million. If these high prices encourage new entry, these prices and deadweight losses will fall, but at the additional cost to the country of building new and unnecessary power stations.

Newbery found that if the CEGB had been split instead into five firms of equal size, then the impact of these undesirable features would have been substantially reduced. Indeed, even splitting the existing power stations between two equal-sized firms would improve on the present system, in which power stations are unlikely to be operated in the true merit order. Newbery acknowledged that there is little resemblance between the present situation and the gloomy picture his results suggested. Pool prices are now low, and the companies have signed contracts at rather modest prices. Although this is a possible equilibrium, there is little to prevent the generators from moving to a higher set of prices. If the companies have contracted for more supply than consumers actually demand, as seems to be the case at present, they have an incentive to keep the pool price low. In future, if the companies sell fewer contracts and only accept contract prices that are roughly comparable to the spot price, their incentives to charge higher spot prices will increase.

Although the Director-General of Electricity Supply is not formally empowered to regulate the generators, Newbery noted that he has a general duty to promote competition. If prices rise far above costs, he may refer the companies to the Monopolies and Mergers Commission, whose natural and economically attractive remedy would be to dismember the supply industry, ideally into five equal-sized companies. There are no precedents for such drastic action in the UK, however, and while fear of potential regulatory action may keep the companies to a lower price strategy, this places too much reliance the regulator's ability to escape capture. The UK government has argued that entry by new generators will reduce market power over time. Newbery suggested that this process be actively encouraged by either requiring that any station due for closure must be offered for sale as a going concern at `site-and-scrap' value or restricting the fraction of new capacity that the existing companies are allowed to build.