London, 18 October 2011: Reuters

The UK government's decision to hold an "energy summit" with major power and gas suppliers is a piece of political theatre -- but also a belated recognition the country's liberalised energy markets are not working as intended. The summit is meant to deflect anger over mounting utility bills, which threatens to derail the government's clean energy investment plans. Opponents will decry it as an empty gesture.

But that would be a mistake. There are valid concerns about the way the country's energy markets and supply system have evolved, and whether the current structure operates in the best interests of residential and industrial customers.

The summit comes as Britain's Office of Gas and Electricity Markets (Ofgem) is conducting its own review of pricing and competition -- hiring accountants BDO to conduct an independent study into transfer prices, profits and hedging strategy at the country's six largest power and gas suppliers. The review is likely to lead to a shake up in the way power and gas are priced to improve transparency.

VERTICAL INTEGRATION

Britain's gas and power markets have a number of features that give cause for concern because they could (potentially) facilitate higher pricing than would be expected in a more competitive market. Just six firms dominate supply to households as well as small- to mid-sized commercial and industrial energy users (British Gas, E.ON, EDF, Scottish Power, Npowerand Scottish & Southern).

Such a high level of concentration may be justified but should always be a red flag from a competition point of view since it facilitates possible collusion. It is far higher than the government envisaged when the gas and power industries were privatised and distribution businesses were carefully separated from transmission and generation.

The big six are all integrated firms that produce their own power and gas, trade on wholesale markets, and act as utility suppliers to households and businesses. They deny earning excess profits supplying households and other small users. But the degree of vertical integration inevitably increases risks around transfer pricing.

Ofgem this month said the companies' profit margin had risen to 125 pounds ($197.5) per customer per year, and will remain at 90 pounds next year even after allowing for a further increase in wholesale costs. If Ofgem's figures are correct, the companies are earning a margin of 7-9 percent on an average combined gas and electricity bill of 1,345 pounds per household.

The companies dispute these numbers. British Gas says it made just 24 pounds after tax for a household taking both gas and electricity, and Scottish and Southern Energy (SSE) estimated its margin was 62 pounds. "The approach adopted by Ofgem in calculating this figure is entirely theoretical and does not reflect how a responsible energy supply business manages its energy procurement strategy in reality", SSE told the BBC.

TRANSFER PRICING

In recent years, the big six have repeatedly complained about losses or small profits in retail distribution. The lack of profitability is surprising. If the companies really were earning such poor returns, some of them would surely have exited from the sector.

However, returns on retail distribution depend on the price at which downstream distribution arms buy power and gas from the upstream producing and trading businesses. In any industry, such internal transfer pricing creates potential to shift profits from one part of the business into another depending on where they attract the most favourable tax or regulatory treatment.

Like any other regulated firm, power and gas companies have a strong incentive to shift as many costs as possible into the regulated business, where they can use them to push for price increases, and as much of the profits into the unregulated business, where do not draw so much scrutiny and may be given more favourable tax treatment. Lack of profits in distribution may therefore be more apparent than real.

RETAIL PROCUREMENT

In theory, the retail arms of the big six should buy power and gas from their production and wholesale arms at "arm's length" prices reflecting transactions with third parties on the open market. However, using arm's length pricing to solve the transfer pricing problem is notoriously difficult to enforce. In this case, the same firms dominate both sides of the wholesale market. They supply most of the power and gas and appear on the demand side as the major purchases on behalf of retail and business customers. It is hard to have an effective reference price when the buyers and sellers are essentially the same.

Acting as the buyer for a large number of semi-captive customers as well as owning a wholesale trading operation and sources of supply also gives the big six considerable optionality to trade around. This may be cured by imposing a Chinese wall between traders sourcing power and gas on behalf of the  regulated utility business and traders who are selling power and gas on behalf of the producing and trading arms. But will a trader procuring gas for the utility drive as hard a deal when the counterparty is another part of the same firm?

TARIFF STRUCTURE

Retail arms of the big six reduce gas and power price volatility for households and businesses by offering contracts with prices fixed for 3-12 months at a time, while sourcing energy on spot and forward markets at a mix of fixed and spot prices.

In smoothing volatility for households and businesses the big six are performing a valuable service and assuming short-term price risk for which they should receive compensation. But the question is how big that compensation should be, and what happens when volatility simply shifts profits from one area of the firm to another?

There is a lingering suspicion retail and business customers are paying too much for "price certainty" and are effectively buying expensive futures and options contracts from the distribution companies at non-competitive prices. Another concern centres on the complex multi-part power and gas tariffs offered to households and small firms. Complexity is often justified as offering customers more choice, but in reality it may simply be used to make price comparisons much harder.

Mobile phone companies have demonstrated how to successfully limit direct price competition and obscure costs by offering complex tariffs. There are suspicions the big six have also resorted to complexity for the same reason.

In a final area of concern, the big six often pre-announce price increases some weeks or even months of them going into effect. Potential price rises are trailed in the media even further in advance. There can be innocent reasons for this sort of behaviour. The big six are under a statutory obligation to give customers advance notice of price changes. But pre-announcing price increases can also facilitate "price leadership". The first company to announce a rise can see if its rivals follow suit before deciding whether to implement the increase.

TRUST BUT VERIFY

The big six have already made changes, confirming some concerns are legitimate. Doorstep sales of complex and confusing tariffs have been suspended following criticism about the misleading tactics used by sales staff. SSE last week said its power would be sold on the open market rather than going straight to its supply arm, according to the BBC.

But the industry needs to go much further to create transparent and competitive markets. Ofgem's study into transfer pricing is a start, as is the regulator's proposal to require each of the big six offers at least one simple tariff (with a standing charge and flat rate for power and gas) to facilitate price comparisons.

However, the industry needs a much greater degree of separation between production and trading on the one hand and retail supply on the other, and far more heterogeneity in the retail sector in terms of procurement strategy to offer customers a genuine choice rather than just a confusing menu of options all of which are in reality the same.

Ends --

The views expressed here are his own.