Overview and Analysis of the Energy Generation Industry in the UK - Essay Example

Overview and Analysis of the Energy Generation Industry in UK Grade (March. 12, Table of contents Introduction………………………………………………………………………………….……3 Overview of the UK Energy Generation Industry.…………………………….…………….……3 Overall industry structure…………………………………………………………………………3 Reasoning.…………………………………………………………………………………………5 Possible Future Structure.…………………………………………………………………………7 How the structure may affect the strategy decisions of firms within the sector….…...…………10 Contribution of the UK energy generation industry to the UK economy...…………………….…3 GDP Contribution…………………………………………………………………..……………12 Employment creation...………………………………………………………………………..…14 Investment..………………………………………………………………………………………15 The effects of government sustainability targets on Ecotricity business plan………………...…15 References………………………………………………………………………………….….…17 Overview and Analysis of the Energy Generation Industry in UK Introduction The UK Energy Generation Industry is one of the core industries in the United Kingdom’s economy, owing to the fact that the industry does not only power the whole nation, but also determines the rate of earnings that the other industrial sectors in the economy produces (Willems and Morbee, 2008:17). Energy is the backbone of the manufacturing, transport and commercial industries, such that without efficient energy supply for these sectors, the economy would virtually grind to halt. The UK Energy Generation Industry accounted for 51.8% of the total industrial investment in the United Kingdom in 2010 (DECC, 2013:2). This underlines its major contribution to both the stability and productivity of the economy, not only in its capacity to generate revenues for the economy, but also in supporting the rest of the industries in the economy to maximize their productivity. This report seeks to analyze the structure of the industry, with a view to evaluate the reasons for the structure and the strategic decisions that are influenced by the structure of the industry, as well as the possible future structure of the industry. The other subject of this report will be the analysis of the contribution of the UK energy generation industry to the economy, especially as related to the value added by the industry to the country. Finally, the report will also assess the effects of government sustainability targets on the business plan of Ecotricity, as one of the organizational players within the UK energy generation industry. Overview of the UK Energy Generation Industry Overall industry structure The number of firms operating in an industry and the nature of the competition that exists in the industry defines the industry structure. Oligopoly is a market structure that refers to the operation of a few big companies in the market, such that the competition level between the few operators is relatively lower, compared to the competition level in a perfect market competition (Waddams, 2008:125). The UK Energy Generation Industry is characteristic of an oligopolistic industry structure, owing to the fact that the industry is dominated by a few firms, such that it is a concentrated market (Oxera, 2008:33). A concentrated industrial market has a few big firms operating at the apex of the pyramid, while the rest of the small firms are operating at the base of the pyramid. Thus, the UK Energy Generation Industry is characterized by a few firms that controls the largest percentage of the market share, also referred to as the ‘big six’, while the rest thousands of small companies are left to share the rest of the small market share (Waddams and Wilson, 2007:6). Virtually the whole of the energy industry is controlled by the six big companies, which cumulatively share 99% of the market share, leaving the rest of the small firms in their hundreds to share the 1% of the market share in the industry (Thomas, 2006:584). The graph below shows the market share held the big six firms in the UK energy industry: Fig 1: MAtket share of he Big Six Firms in the UK energy industry In this respect, the customers have very little choice in the supplier from whom to purchase energy supply, owing to the fact with the little number of the big firms controlling the larger percentage of the market, between 40% and 50% of the customers have stuck with a single supplier for more than 10 years (Ofgem, 2011:12). Reasoning The UK energy industry was privatized in 1990 by the conservative government, in an attempt to make the energy industry a more competitive industry, since the supply of energy by the previous government companies was expensive for the consumers (Nalebuff, 2004:187). The government got around the high expense problem by privatizing the energy sector and then creating three different sub-sectors within the industry, namely the energy generators, energy suppliers and energy distributors (Muroma, 2004:45). Nevertheless, while the privatization of the energy industry in the UK was a noble idea meant to enhance competition in the industry, the real effect was to create what has come to be known as ‘comfort oligopoly’ (Ofgem, 2004:36). The private suppliers immediately realized that it was more economical to work in more than one segment of the industry, and thus they quickly formed vertical integrated mergers that consolidated the energy industry in the hands of a few. Following these mergers, most of the companies serving in the energy generation sector also operate in the energy supply and the energy distribution sectors (Joskow, 2000:11). Consequently, the UK energy generation industry has been concentrated in the hands of a few operators, thus forming an industrial market structure that constitutes an oligopoly. The figure below shows the share of the number of customer energy accounts shared between the big six and the smaller suppliers in the UK energy industry. Fig 2: Number of customer energy accounts sharing between the big six and the smaller suppliers in the UK energy industry The same companies that serve in the supply segment of the UK energy industry are the same ones that have dominated the energy generation segment. Thus, the big companies account for 72% of the power generation in the different energy generation subsectors of the UK industry, while the same big six companies own over 75% of the power generation stations in the UK (Hunt, 2002:14). The effect is that the consumers of energy, whether the households or the commercial consumers are left at the mercy of the big six operators in the energy sector to determine price rate at which the energy is sold to the consumers. The big six companies alone supplies 99% of the UK households, and due to this high dependence of the few operators in the industry, the price of energy supply in the UK has gone up by 90% in the last decade (Ofgem, 2011:18). The consumers are the biggest losers in these energy price hikes, owing to the fact that it is the consumers who suffer the spiraling of the energy bills that they have to clear with every billing period, creating a massive consumer exploitation that is unfortunately not controllable due to the relatively low competition in the UK energy generation industry. The figure below shows the share of energy generation for the big six companies: Possible Future Structure The Competition and Markets Authority (CMA) has found that the big six suppliers are overcharging the individual energy consumers an extra of up to £234 a year, compared to the consumers who shop around the small energy suppliers. The CMA finds that on standard, the sticking consumers could have saved between £158 and £234 a year if the consumers could agree to switch from their traditional energy suppliers to shop around the new and smaller suppliers (DECC, 2013:29). This is an indication that there is a likelihood of the future structure changing from an oligopoly to a more competitive markets, for example a perfect competition market, should the consumers take advantage of the possible reduction in their energy bill costs by switching from the big six suppliers to the new and smaller suppliers. Further evidence that the future structure of the UK energy generation industry may tend towards a perfectly competitive market is the fact that the small actors in the energy industry have been challenging the big six firms operating in the industry for market share at a very fast rate. While the market share for the small firm operators traditionally ranged between 1% and 2% market share for the 12 year period since the 1990 up to 2012, the scenario has been changing, with the small operators in the UK energy generation industry increasing their market from 2% in early 2012 to almost 9% (DECC, 2013:24). This is an indication that the structure of the industry may change towards a perfect competition industry structure, as a result of increasing competitiveness in the industry. The small operators are consolidating their gains at a very fast rate, which then means that the intensifying of competition in the UK energy generation market industry may not take long to effect. For example, First Utility, a leading small operator in the UK energy generation market has been increasing its rate of recruiting household customers for the supply of energy, and thus has been able to increase its customers by more than triple to the current customer standing of 650,000 (DECC, 2013:23). The trend is also observable in another small operator firm in the UK energy industry, where Ovo Energy, a small and new industry operator in the UK energy generation industry that just started in 2009 has been able to increase its customers from the initial 140,000 customers to the current 400,000 customers (Ofgem, 2011:13). This trend points to the possibility of the future industry structure in the UK energy generation industry transforming from an oligopoly to a perfect market competition structure. The big six operators in the UK energy generation sector have been reaping big profits from the energy generation segment of the business. The graph below represents the profits in £ millions, made by the big six firms operating in the UK energy generation sector for the last five years: Fig 3: A graph of aggregate profits from energy generation for the big six firm The CMA statistics have also indicated that between 60% and 70% of the consumers have stuck with their traditional energy supplier for over 10 years, or at maximum switched their energy suppliers only once in the last 10 years (DECC, 2013:7). The effect is that the consumers have developed high dependency on their traditional suppliers, most of whom are the big six operators in the UK energy generation and supply market. This dependency has also caused an unprecedented hike in the prices of the energy supply to the consumer, with the prices increasing at between 80% and 90% in the last 10 years (DECC, 2013:18). This has caused the energy prices debate to rank high in the political agenda, with the political campaigns hitting on the issue of lack of healthy competition in the energy sector, while offering to institute measures that will reduce the prices of energy supply and introduce more competition among the firms operating in the sector. The political agenda has required that the Competition and Markets Authority “repair the market and make it work for everyone, not just the suppliers” (Ofgem, 2011:5). In this respect, there is a high likelihood that the future structure of the energy generation market in UK will tend towards perfect competition market structure, if the political and institutional recommendations such as those of CMA, to increase competition and lower prices, are implemented. How the structure may affect the strategy decisions of firms within the sector The energy generation industry in the UK is highly associated with strong business relationships being forged to foster close relationship of the firms operating in the industry, as opposed to competing (Pearson, 1981:91). While there might exist a certain level of competition in such a market structure, the level of competition is lower compared to a perfectly competitive market, while the nature of competition may also differ from the one in a perfectly competitive market. An oligopolistic structure within an industry forces the firms to operate under non-price competition, through enhancing price interdependence among these firms (Hunt and Shuttleworth, 1997:77). Consequently, the firms may compete on the basis of branding or differentiating their products such that they may seem more appropriate and appealing to the customers, but ensure to sustain the range of prices for the products at the already established industrial level prices. This is because; in an oligopolistic market, the action of one firm affects the other firms markedly, owing to the fact that in such a market structure, there are only a few firms that controls the industry or the market (Joskow, 2000:51). Thus, it is likely to establish game theory as the most applicable theory in the decision strategy of the firms operating in the UK energy generation industry. The concept of Game theory offers that one firm within an industry must consider the action of the rest of the firms serving in the same industry, since the actions of the firms within the industry are highly interdependent (Henney, 2006:42). This theory of decision making strategy is highly applicable in the UK energy generation industry, since should one firm decide to increase its prices, the rest of the firms may fail to follow the lead. This way, the firm increasing its prices will lose its customers and market share to the rest of the firms operating in the market. On the other hand, should a firm in an oligopolistic industry decide to lower its prices, the rest of the firms will be forced to follow suit and reduce their prices, since failure to react in this manner might see the firms losing their market share to the firm that has already reduced its prices (Helm, 200345). Consequently, it becomes very essential that the firms operating in an oligopolistic industry cooperate in aspects of pricing their product, while leaving competition to other aspects of their businesses, other than price. The fundamental factor determining the entry and exit of firms in the energy generation industry is the heavy investment requirement (Helm, 2003:48). In this respect, most of the firms that enter the energy generation industry are well capable of investing huge sums of money in the equipment, licensing distribution chain and logistical requirements, all of which are very expensive. Therefore, while it is very hard for a firm to enter into the energy generation industry due to the high entry barriers that are set by the huge investment requirement, exiting the industry is equally hard, because of the potential high loses that a company stands to incur, if it has to exit the energy generation industry (Green, 2004:39). For this reason, it follows that most of the firms operating in the energy industry are traditional firms that have been in the industry for long, and even when the revenue and profit earning capacity for such firms decline, the best alternative for the firms is to merge, rather than to exit the industry and incur the huge losses on initial investments (Nalebuff, 2004:185). It therefore follows that the oligopoly structure of the UK energy generation industry may affect the strategy decisions of firms within the sector, through promoting vertical integration decisions, which in turn tends to reduce the number of the operators in this industry over the years, while massively increasing the sizes of those firms (Oren, 2006:941). Thus, each of the big six companies operating in the energy generation industry is fundamentally a group of companies that have been consolidated together, with interests in both energy generation and energy supply (Defeuilley and Mollard , 2009:387). Therefore there are a significant number of subsidiaries within any of the big companies operating in the UK energy generation industry. For example, British Gas is a subsidiary of Centrica Energy, which has other affiliate companies operating in this industry (Ofgem, 2011:63). On the other hand, EDF Energy is another big firm operating in the energy industry in the UK, which has 37 subsidiaries within the UK alone, while another big operator in this industry, RWE operates a streak of subsidiaries numbering 998 across Europe (DECC, 2013:3). Therefore, most of the decision making in the UK energy generation industry is simply based on inter-firm and inter-group search for the most appropriate and beneficial business decisions that are likely to favor them. This in turn means that both the government and the consumers have little control over the nature of the decisions made by the operators in the UK energy generation industry. Consequently, the customers suffer from a spiraling price increase in the energy bills, while the government has not been able to institute measures that would manage to control the price determination mechanisms applied by the firms in this industry. Contribution of the UK energy generation industry to the UK economy The UK energy generation industry is a very vital industry in the economy of the United Kingdom. The contribution of the industry to the economy does not only occur in terms of the industry contributing to revenue generation in the economy, but also acting as an enabler of all the other industries and sectors of the UK economy, through powering them (Whittaker, 2007:1). GDP Contribution The UK energy generation industry is instrumental in contributing to the economy of the UK in terms of GDP, through the industry contributing 3.8% of the country’s GDP annually, according to the 2012 National Statistics Office data (DECC, 2013:3). However, the contribution of the Industry has been higher in the past years, with the industry contributing 10.2% of the annual GDP of UK in 1982, when the industry’s contribution was at its peak (Borenstein and Shepard, 1996:27). Figure 5: Percentage of UK energy generation industry GDP contribution Thereafter, the contribution of the sector to the economy has been declining, but not to the levels that can be considered insignificant, owing to the fact that the 3.8% contribution of the sector to the UK’s GDP in 2012 is the lowest contribution that the industry has ever contributed to the economy, with most of the contribution of the industry to the economy ranging above 4% to 10% per annum (DECC, 2013:4). The contribution of the UK energy generation industry to the economy has kept varying over the years, owing to the frequent changes in the volume of the petroleum extracted and the prices of such petroleum in different years. The oil and gas extraction contributes the most of the GDP percentage worth of the UK energy extraction industry, by contributing 46% of the total GDP value contributed by the industry, while the second most contributing segment of the industry is the electricity segment, which contributes 27% of the total value contribution of the energy generation industry to the UK’s annual GDP (Dukert, 2009:82). Employment creation The UK energy generation industry is an important industry in the creation of employment within the UK economy. The UK energy generation industry had directly employed a total of 176,000 people by 2012, which accounts for a total of 7% of the whole UK industrial employment (DECC, 2013:4). Further, the industry has provided more employment opportunities indirectly, such that the traceable number of the people who are indirectly employed by the UK energy generation industry amounts a total of 207,000 people (DECC, 2013:4). Fig 5: A graph of UK energy generation industry employment contribution Nevertheless, while all the people working under different segments of the industry indirectly are considered, the UK energy generation industry has offered employment to people numbering well over 1 million and counting. This makes the industry one of the most important industries in the economy, due to its ability to absorb both the skilled and the unskilled labor, thus capable of serving all range of households within the UK economy (Baldick, Kolos and Tompaidis, 2006:639). Nevertheless, before the 1980s, the contribution of this industry to the employment was much high, but the employment contribution reduced drastically starting the 1980s through to the 1990s, owing to the fact that the coal mines in the UK were closed down during this period (Key Note Publications, 1993:35). The employment in this industry continued to decrease gradually between 1990 and 2005, after which employment started to increase at a slow pace, and has since been growing gradually over the past decade. Investment The UK energy generation industry has also contributed immensely to the investment within the UK economy (Fehl, 2010:13). According to the data from the National Statistics Office, the UK energy generation industry contributed 10.1% of the total investment done in the UK economy in 2010 (DECC, 2013:4). This represents a very significant contribution to the overall annual investment of the UK economy, most especially because the UK energy generation industry contributed over 50% of the total investment contribution to the UK economy in 2010, with its investment contribution amounting to 51.8% of the total industrial investment in the UK (DECC, 2013:4). The effects of government sustainability targets on Ecotricity business plan Ecotricity is a UK energy generation company that has been affected by the government sustainability targets, such that the business plan of the company was developed targeted at generating and supplying power from green ecosystem, as opposed to the using carbon sources (UK Energy, 2009:56). The company was established in 1996, seeking to venture into the renewable energy generation segment of the UK energy generation industry, following the UK government’s enactment of the ‘Increasing the use of low-carbon technologies’ policy, which seeks to achieve an 80% reduction on the emission of greenhouse gases by 2050 (Great Britain, 2012:35). Thus, Ecotricity developed as the first green electricity company in the UK, and has since grown its customer base immensely, with the company currently generating and serving 150,000 customers (Elsevier, 2011:776). This ranks the company among the largest energy companies in the UK, outside of the ‘big six’. Therefore, the effect of the government sustainability targets of reducing the carbon emission by 80% was to stimulate the development of a new company actor in the energy generation industry of the UK, under the name of Ecotricity, which focused purely on generating energy from the green ecosystem. References Baldick, R., Kolos, S., and Tompaidis, S, (2006), Interruptible Electricity Contracts from an Electricity Retailers Point of View: Valuation and Optimal Interruption, in Operations Research, Vol. 54, No. 4, pp. 627-642 Borenstein, S., Shepard, A., (1996), Dynamic Pricing in Retail Gasoline Markets, Rand Journal of Economics, 27. Chao, H., Oren, S., Wilson, R., (2005), Restructured electricity markets: Reevaluation of vertical integration and unbundling, Tech. report, EPRI Technical Paper. Defeuilley C. and Mollard M., (2009), The Dynamicof Competition in Presence of SwitchingCosts. 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