This comment has now been re-published as an opinion on the Oxford Martin School website.
Even in the aftermath
of the referendum, there are two power sector stories that (almost) stand on
their own. The first, a Competition and Markets Authority investigation of the retail energy market (gas and electricity) was the
subject of an
earlier comment. The second, covered here, is the House of Commons Energy
and Climate Change Select Committee on the case for breaking up National Grid. Both reports fail
to take proper account of the impact we should expect from commitment to a low
or zero carbon economy. The market and competition paradigms that have
dominated since the 1980s now need re-examination and if necessary
re-interpretation. I argued that a new system architecture, especially for the
power sector, may lead us to promoting much more effective competition in retail
supply. But in the case of the grid there are some powerful counter arguments,
not against competition per se, but in recognition of the necessity for
ensuring a strong National Grid to handle the transitions to a low carbon power
sector.
Select Committee
makes the argument for breaking up National Grid
The Select Committee on Energy and Climate Change
has in its report
on low carbon infrastructure recommended the breaking up of the National
Grid. One of the key complaints about the current structure of the power sector, and the role of
National Grid in particular, is that National Grid suffers severe conflicts of
interest, the most obvious being its ownership of profitable assets such as interconnection
facilities, along with the responsibility for transmission and system
operation, both of which are regulated as public service activities.
Prima
facie this is a legitimate concern in the context of the power sector as it is
today. In essential respects, competition, regulation and industry organisation
all reflect development of the market paradigm established with the privatisation
of the power sector in 1990. This was based on unbundling of the different parts
of the power sector – generation, transmission, distribution and supply.
Generation is a competitive activity, while transmission and system operations
(as well as distribution) are natural monopolies that are granted to a private
sector business in return for being subject to price regulation controlling the
return they can make for their shareholders and the quality of service they
provide.
First
principles of regulatory economics dictate that there potentially serious conflicts
of interest arise if a business is allowed to operate in both a regulated and a
competitive business at the same time. A body such as the National Grid can, under
these conditions, try to do a number of things to promote its own interest to
the detriment of both its competitors and the public interest. These include:
·
moving costs
from the competitive business (the interconnection assets) to the regulated
monopoly, thus allowing their recovery as costs necessarily incurred to keep
the system going. This ends up as a subsidy to its own competitive activities
to the detriment of competing generators.
·
operating
the system in such a way as to advantage its own assets, thereby increasing its
revenues to the detriment of competitors and the public.
·
determining
its investment programmes in such a way as to advantage its own (interconnection)
assets.
·
investing excessively in transmission assets – “gold
plating”- in order to increase the asset base on which it is allowed to earn
its regulated rate of return (although this can arise even for a transmission
only business).
There
does not appear to be much evidence that National Grid is abusing its position
in any of these respects. Indeed a prime
function of Ofgem, the regulatory body, is to monitor these activities and
prevent abuse. National Grid says it has put safeguards in place to keep competitive
and monopoly functions separate. Even so there is is a case for separation of
activities, in order to eliminate even the possibility of abuse, and it this
argument that underpins the Select Committee report.
The
Counter Argument
There
are however some powerful counter arguments. The drive to a low carbon economy is
going to bring profound changes to the power sector. These start with questions
of technology and scale but they have huge ramifications. Conventional assumptions about markets, regulation
and governance are coming under increasing pressure. Some of these challenges sit at the heart of
the Oxford
Martin Programme on Integrating Renewable Energy, and it is worth rehearsing
a few of them, drawing on some particular challenges for energy markets already identified
within the programme.
1. First it is increasingly governments that take the key
decisions on investment. This is for some very powerful reasons that we
identify and which reflect both climate policy imperatives and wider policy and
market uncertainties. Given that governments lack any technical competence in
the power sector, the role of organisations like the National Grid is more and
more important.
2. Second, traditional divisions between businesses are
increasingly difficult to sustain. Generation and transmission investment have
always been substitutes to some degree. To that we can now add storage of
electricity. Storage has traditionally been viewed in relation to its generation
potential (ie the competitive part of the sector) but is increasingly seen as
an instrument in managing the networks, both transmission (high voltage) and
distribution (low voltage). Segmenting what might or might not be a competitive
activity will be increasingly difficult.
3. Third, conventional wholesale market structures, designed
for fossil fuel generation, are not really compatible with the technical and
economic characteristics of low carbon power generation. Inflexibilities,
intermittency, zero marginal cost and other factors render the old merit order an
inappropriate basis for efficient dispatch of generating plant. Without major
re-design these markets will provide neither a signal for the right kinds of
new investment, nor a basis for efficient and secure operations. National Grid
sits at the centre of this issue.
4. Fourth there is still a great deal of uncertainty around
the scale or scales at which the key operating and investment decisions in the power
sector will be made. One plausible direction is a move towards much greater
decentralisation of generation, storage and system control, combined with much
more emphasis on the consumer as an active participant in energy markets. We
may see much more localised approaches to network management. But the benefits
of capturing diversity, in consumer loads, storage options and intermittent
generation, are such that interconnection within national systems is likely to
remain of fundamental importance. This
will not eliminate the role of the Grid; it may well enhance it. And the
technical expertise embodied in the current structure is not an asset we should
put at risk.
5. Finally, there is always a balance to be struck in
industrial organisation between the benefits of specialisation/ unbundling/ competition
on the one hand, and coordination and the minimisation of transaction costs
(between unbundled entities) on the other. Nowhere is that more important than
the power sector, where real time balancing of loads requires strong elements
of control at different voltage levels. The nature of the low carbon economy tilts
that balance towards coordination, and a strong role for the National Grid.
Conclusion
For
these reasons I believe that a cautious approach is justified in looking at the
future of the public service and utility functions carried out by the National
Grid. This is not to dismiss the concerns of the Select Committee. Indeed we
know that, to meet the challenge of a low carbon future, there needs to be a
fundamental overhaul of the system architecture for the energy sector as a
whole and the power sector in particular. But to embark on a re-organisation of
National Grid, in the absence of a clearer vision of where we need to get to,
and focusing on issues which in a sense are problems of the old paradigm, may
be a mistake. To do so without a clear direction of travel will simply add to
the policy uncertainties that the Energy Institute has already identified as a
major problem for new investment.
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