The first decade: The Pool and its demise by Nigel Cornwall

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IN this series of four features, Nigel Cornwall is taking us on a journey over the 30-year history of GB Electricity Market.

Nigel Cornwall is a well-known energy industry commentator and founder of Cornwall Insight.

His latest venture is New Anglia Energy, which is a company formed to support local energy markets in Norfolk and Suffolk.

Its purpose is to demonstrate learning by doing, using the knowledge and relationships developed by Nigel in a long and fruitful career in the energy sector to support local stakeholders and initiatives.

The introduction to the four features, published earlier this week, is available here

 

 

In the first part of this series, Nigel will be looking at the Electricity Pool of England and Wales.

 

Background to deregulation   

“The third Thatcher government had been returned to power in June 1987 following a landslide general election victory that gave it a working majority of over 100.

Its election manifesto included a clear commitment to privatise the electricity industry within the lifetime of the parliament.

The aim initially was try to get this done by 1990 at the latest but in the event the process took longer, with the main company sales not being completed until end 1991.

The Conservatives had first tried to introduce competition to the electricity market (albeit unsuccessfully) in 1983 with the Energy Act of that year.

It then turned its attention to British Telecom, which it privatised in 1984, and then British Gas, which followed in 1986.

By then popular capitalism – and Sid – were firmly part of householder culture, and the sale of the electricity companies was structured to have mass market appeal.

The new administration hit the ground running and the electricity industry in England & Wales (EW) and Scotland, after a couple of delays, notably around pulling the nuclear stations from the sales process and retaining them under the state-owned Nuclear Electric, was legally restructured on 31 March 1990 (the so-called “vesting process”).

This was achieved despite the initial opposition of the CEGB, whose management initially fought hard to keep the empire intact.

The process was overseen by two secretaries of state, first Cecil Parkinson and from July 1989 John Wakeham.

As a key enabler, a new electricity regulator OFFER was established, with leading academic Professor Stephen Littlechild formally appointed as the first Director General for Electricity Supply in October 1989 following passage of the Electricity Act 1989.

The legislation provided for the new operating licences and a fully independent legal structure for the regulator.

The sales of the electricity companies took place as a rolling programme because of the scale of the offering between November 1990 (the 12 Regional Electricity Companies, which were the successors to the Area Boards), February 1991 (first wave of the two England and Wales generator sales, with follow on sales in 1995) and June 1991 (with the sale in full of the two integrated Scottish companies).

The total proceeds from the sales to end 1991 was £14.5bn (just over £10bn for equity, the rest in the form of debt).

The sale of the RECs was seen as rather generous, partly due to changes in the market after the combined prospectus was issued; the generators and the Scottish companies that followed were much less so.

The competitive wholesale market in the form of the England and Wales Pool opened for business on 1 April 1990.

At that time the pre-restructuring trading arrangements were retained in Scotland with the integrated companies essentially separated from the EW market by interconnectors.

The removal of the old supply franchises was effected in three steps: in 1990 the above 1MW market was opened, with the 1989 Act providing for further wind-downs of regional franchises in 1994 (the above 100kW market) and 1998 (full retail competition).

The first tranche opened up competition to 30% of the market; the second to a further 15%; and, the final wave extended to the domestic retail market, whose peak load represented about 55% of the market.

The Pool was a mandatory market.

Generators and suppliers through operating licences had to trade through it, which provided a last resort market for all but de minimis trades.

It provided a mechanism for dispatching generation to meet demand.

But its design was hurried through driven by the political imperative of getting the job done well ahead of 1991, which was seen as being the last date at which the next general election could reliably be deferred.

Getting the sales done largely to time was a major achievement, especially given the need to establish the market framework from scratch, and it is easy now with the benefit of hindsight to be critical of the initial market design.

Basically the design of the Pool was entrenched around the generation scheduling and dispatch optimisation programme used by the monopoly CEGB.

But it was a one-sided market, with generator offers being taken at the day-ahead stage for individual half-hourly trading or (settlement periods) the following day.

These were stacked in price order, and a centrally calculated demand forecast was produced by National Grid on behalf of the Pool for the following day and applied giving rise to 48 unique prices.

This auction-based Pool Purchase Price was then paid to all generators who were in the generator schedule.

A number of adjustments were then made to reflect changes on the day and actual dispatch, and a capacity payment added, and all suppliers paid this Pool Selling Price.

The whole process was completed within 28 days, when the final prices would be published in the Financial Times.

To help manage the risk of price volatility, a dense framework of financial contracts – CfDs – was brokered by government, and it became the practice to renew these annually.

These were two-way contracts.

If the price was lower than the contract strike price, the supplier paid back the difference; and if the price was higher, the generator rebated the surplus.

 

Gathering stormclouds

The Pool had problems from the start.

Notably the price setting process was based on a very complex algorithm that lacked transparency using complex generator schedules and dense operating parameters.

The calculation for setting capacity payments was also complex.

A number of unavoidable costs arising from system operation and variations against forecast were added alongside this capacity adder to produce an adjusted price for each half hour.

It became clear very quickly the process was game-able.

Indeed few thought at the time that the process was anything other than a complex process to deliver a generator’s revenue aspirations.

There were several regulatory investigations over the early years. With only two large generators – National Power and PowerGen – but from the same lineage, the operators had an intimate knowledge of each other’s portfolio.

As early as 1992 OFFER was considering applying yardstick competition to purchasing costs (though it held back from doing so).

But it did find price manipulation and at one point even led to a pool price cap, which was applied between 1994-96.

New entry did occur, but initially it was mostly from the new suppliers.

In all 11 of the 12 in England and Wales entered the generation market.

Many believed at the time that they broke their economic purchasing obligations, but OFFER dismissed these complaints allowing them to diversify presumably on grounds that this was the lesser evil.

Then in early 1994 the regulator brokered a deal under which 6GW of generation was sold by National Power and PowerGen to supplier Eastern Group.

But, while generators also looked to move into supply, these moves were blocked until 1998.

At the retail level, deregulation occurred largely to the legislated timetable.

A milestone was the phased extension of competition to the so-called 100kW market in 1994.

While the opening of the +100kW market did not proceed well, it was nevertheless completed to time.

And the final market opening took a lot longer than expected – and was hugely expensive – but was completed by 1999.

As important the governance of the rules was rigid and dominated by the incumbents, and recognised defects were not addressed.

An annual cycle of changes to the Pooling and Settlement Agreement were brought forward, accessed and passed, but they failed to tackle the main learnings, and many issues were left in the “too hard” box.

By 1996, many commentators were highlighting real defects in the market rules but also the participants lack of willingness to rectify them.

Calls for meaningful change especially from those outside the market and industrial users became deafening.

 

End of the line

The regulator Professor Stephen Littlechild was asked by the new Labour government in May 1997 to undertake a review, within an overarching context of how liberalisation could work “better”.

But the industry failed to respond in any meaningful way sensing it was untouchable.

It was also focused on and distracted by the legal requirement to roll out full competition to the domestic sector.

This happened sequentially over eight months between 1998 and 1999.

The review carried out by Littlechild was published in mid 1998. It noted that, in some respects, the Pool had worked satisfactorily.

The deregulated marketplace had maintained the quality and security of supplies, and the trading and pricing arrangements had enabled generators to enter the market and allowed competition in supply to be introduced.

But it also found that many stakeholder concerns were justified.

In particular generator offers were not cost-reflective and movements in generator prices had not matched reductions in costs.

Since 1990 wholesale electricity prices had been largely unchanged, while the costs of generation in terms of fuel costs and capital and operating costs had reduced by almost 50%.

Crucially the trading arrangements had facilitated the exercise of market power at the expense of customers by enabling all generators to receive a uniform price which in practice had been set by just a few of them.

The regulator said it was likely that this encouraged excess new entry at the expense of existing plant, especially new gas plant.

OFFER found that the single Pool price also inhibited supply side price pressure.

There was limited involvement of the demand side, which had probably caused higher prices overall but also sharper price spikes than otherwise would have been the case.

The complexity and opacity of the Pool’s price setting process and the lack of competition in price setting also inhibited the development of derivatives markets and reduced liquidity in the contracts market, increasing prices to customers.

The capacity market was also not functioning properly.

It did not provide an effective short-term signal to encourage both sides of the market to respond to rapidly changing circumstances.

Indeed, capacity payments had not worked as intended. In years when capacity payments had been low, generators had increased system marginal prices; they thus provided a poor long-term signal for the need for capacity.

More generally generators and suppliers did not face fully the costs and the consequences of their actions because neither group made firm commitments to generate or consume electricity.

Governance also came under the cosh. Pool governance arrangements were inflexible and had precluded change or delayed reform.

Customers had only since mid-decade been allowed to participate in Pool governance, and still had no voting powers and crucially the regulator did not have the vires to take steps directly to secure change to the rules.

The trading arrangements were no longer at the cutting edge as they once had been, and experience elsewhere showed that where electricity liberalisation shows a trend towards market-based solutions.

We will pick up the vision of the new trading arrangements – actually deliberately not called a Pool – next time, but it was based on a radically different design philosophy.

But from late 1998 the Pool was declared officially beyond its sell-by date.

Tony Blair’s ministers had accepted the regulator’s diagnosis and the government endorsed a shift to a new style of market, which was very unlike anything else anywhere else in the world.

The regulator at long last also managed to broker agreement with the two main generators to divest a further 4GW each of coal generation, in return for consent for their acquisition of some of regional supply companies.

The story of the decade does not end there.

Another report on prices in 1999 by OFFER on prices in the Pool concluded that the trading arrangements facilitated the exercise of market power.

And, while the fate of the Pool was in effect sealed, parallel review streams continued to drive change in the generation sector.

This resulted following a temporary moratorium – the so-called stricter consents policy – confirmed by the conclusions of the Review of Energy Sources for Power Generation published in April 2000.

Both of these landmark contributed to the Utilities Act of 2000.

“This was the new government’s first major energy legislation, and it set out the vires to introduce NETA.”