United Kingdom Energy Industry Crisis - Coursework Example

United Kingdom Energy industry crisis GhalibWalidKutbi Mr Terrence and Mr Sam Economics work due: 4 February, 2014 Introduction Energy, as a good is a necessity. Energy has many uses and therefore satisfies many wants both to households and firms. It’s worth noting that many energy products have a relatively inelastic demand. In UK, the energy market has been a subject of debate with OFGEM being suspected to be inefficient. OFGEM (which in full refers to; Office of gas and electricity markets) is an organisation that governs energy market in UK. Many scholars suggest that, Energy market operations tend to favour suppliers, as shown by the increased margins of profits as well as price rise. However, the fact that consumers don’t complain about the market operations provokes thinking that the market is fair to both buyers and sellers. But this is not the case since consumers silence might be led by the inelasticity of demand. The main mandate of OFGEM is to set rules and regulations, implement them and maybe punish firms who act against customer satisfaction. With close link t the government, OFGEM ensures that energy regulatory system remains sound in that it protects consumers as well as ensuring a cost effective investment. So far, OFGEM has initiated new entrant protection plans such as regulating the big six firm’s tariff plans made to bar customers from shifting. As matter of fact, each policy that OFGEM, as it will be shown later in this essay, reduces the big firms power making the environment better for consumers and new entrants UK energy sector The UK energy sector is divided into three sections; energy generation, energy transportation and energy supply. The three sectors are open and allow other firms to enter. However, the six firms tend to combat the market making it hard for new entrants. As matter of fact, government does not produce energy in UK, neither does it control price. Therefore, the quantity of energy supplied barely depends on market forces and so does the price. The existence of several suppliers gives the buyer an opportunity to choose where to buy from. The big six offer many options for customers to choose from. There are also independent suppliers. As noted earlier, prices are higher than the competitive market price, and increase more than the cost of production. The price of gas and electricity showed an increasing trend between 2007 and 2013, and is expected to rise higher by 2020 if not regulated. This increment signifies a rise in supplier’s power to raise prices and hence, a prove that the market is not a competitive market structure (Sloman and Garratt 2013). Moreover, firms in the generation sector are experiencing a decline in profits, whilst the suppliers’ profit margin is increasing (appendix fig. 3). Profit increased between 2009 and 2010, declined a bit in 2011 and then started rising again. Non-domestic supply firm’s profit remains relatively stagnant. Therefore, we can say that the suppliers’ profit increase comes from the way they raise price. This monopoly power comes from various sources. To start with, energy consumption has increased. The demand for gas, electricity and other fuels has increased by more than 5% in the last few years. Production has also increased but at a lower rate than the increase in demand, making energy demand more inelastic to price changes (Allen et al 2013). Secondly, there are hidden barriers to entry and the industry is less profitable to small independent suppliers. Though, consumers make their choices freely, the big six companies provide inadequate information, that make consumers to prefer their products. The Herfindahl-Hirschman Index shows an increasing trend since 2007,a prove that more firms are leaving the industry than others are joining. High initial costs and difficulties to acquire market share explains the slope of Herfindahl-Hirschman Index. The percentage of income that consumers spent on the product increases; hence there is an increase in necessity level. The big six firms are aware of all these factors and hence take advantage and disfavour customers to maximise their profits. There is no evidence of collusion, or any leading firm but all firms pricing policy act against improving consumers’ favour. Market structure As a result of market imperfections, Energy products prices in the UK economy are fixed by suppliers but not market forces. It’s for this reason that OFGEM exists to regulate market operations. Markedly, there exist several sellers. Therefore the market structure is neither a monopoly nor a perfect competitive one. It’s actually an oligopolistic market, with six firms dominating it. Note that there are six big firms that dominate the industry, determining prices due to their high market share. Besides, though the commodities have company brands, especially in gas supplies, the products are not highly differentiated and thus give customers ability to shift their purchase location (Leggett, 2014). Worse though, their selection is relatively limited to the big six, though there exist a variety of options and tariffs offered by these major companies. The main aim of privatisation of the UK oil industry in the 1990’s was never attained. Competition has been weakening as the first movers in the industry, that is the big six firms, maintain their market share. OFGEM tries hard to induce the incentive to compete but market entities literally fight against it (Allen et al 2013). As matter of fact, the buyers by not shifting from one product to another regularly contribute towards the stability of the oligopolistic market structure. Customers hardly shift their tariffs as many do not realise that shifting might be a saving plan. By intense Research and design, suppliers are aware of the buyer’s weakness and thus offer biased information (Sloman and Garratt 2013). Many tariffs are branded with short term discounts that seduce buyers and hence these customers end up spending more in the long run. Note that despite the existence of many options, customers use gas and electricity more than any other product. As shown in the diagram below, space heating and water heating, which comprise the highest percentage of consumption, are mainly done use gas. Lighting is purely electricity while cooking uses only gas and electricity. Fig.1. Obtained from Prospects for and barriers to domestic micro-generation (Allen 2008, p. 534) Electricity and gas suppliers, majorly the big six, understand this overdependence. Therefore there are no price wars as demand is adequate. Also, the firms do not collude but maybe set prices using cost-plus pricing. The big six firms do not compete for market share. Under perfect competition, price is determined by the interaction of supply and demand. Getting adequate data to predict demand is hard in an oligopolistic competition (Sloman and Garratt 2013). In cost-plus pricing, the firm decides the expected profit and adds profit per unit product to average total costs to get the price. OFGEM’s reforms OFGEM is aware of the decreasing competition level and has proposed reforms in the market to curtail the situation. Competition is necessary and lack of it makes both existing and future customers suffer. The first remedy is to simplify the market, and ensure a complete circulation of information to consumers this can be easily achieved through Retail market review (RMR). As expected, OFGEM wishes to increase customer participation in the market operations. Noteworthy, though energy is a necessity, there are many sources of energy. The availability of many sources increases consumer’s bargaining power. It also reduces firm’s power over price regulation. Secondly, OFGEM aims at reducing the market share of the big six, by applying demand side management. Incumbency, advantages and barriers to entry retard competition. These firms prolong customer’s shifting period by offering long-term tariffs. As noted earlier, most tariffs are camouflaged by short-term benefits that rob the customer in the long run (Leggett, 2014). Thirdly, OFGEM suggests that reducing liquidity levels in the many products offered by the big companies harden customer’s shifting making it hard for new entrant to access wholesale products. To resolve this OFGEM has set reforms that regulate liquidity levels of the big six firms. Lastly, OFGEM hopes to reduce vertical integration. Normally, vertical integration reduces prices, due to the reduced number of middlemen. However, in UK, the big six companies vertically integrate to increase their market power (OFGEM, 2014). The retail market could also be expanded by eliminating this vertical integration, in addition to integrating the energy industry with the integrated-wider European country Conclusion The UK energy industry is experiencing serious problems, which are worsening. The main problem is that competition has been decreasing at an increasing rate. Customer’s involvement in the industry has been declining as the suppliers continuously take advantage of this. The overseeing bodies are either reluctant or less equipped to solve this crisis. As compared to the global energy industry, UK energy prices are very high. With the evidence I have discovered I have suggested that UK energy market is dominated by six large firms, which pose barriers to entry and operate in a tacit collusion, reaping high economic profits. OFGEM has set policies and reforms to get back customer satisfaction from this high demand commodity. Firstly, the energy industry has been politicised and the collusion of the government, overseeing bodies and the big six firms make the situation worse. So long as the interests of these bodies collude, then there will be minimal results. Warren (2013) emphasizes that, the demand side management policies are the most effective in solving the UK energy industry crisis; however, to fix this, the policy makers have to make sure that there is no overlapping between the existing and new policies as that would result to confusion and not solution. Bibliography Allen, S., Hammond, G., and McManus, (2008), ‘Prospects for and barriers to domestic micro-generation: A United Kingdom Perspective,’ Applied Energy, 85, pp. 528-54 available at: https://www.ofgem.gov.uk/ofgem-publications/86807/consultationpublish.pdf [Accessed 3 Feb. 2015]. Steuwer, D. (2013). Energy efficiency governance. Wiesbaden: Springer VS. Leggett, J. (2014). The energy of nations. London: Routledge. OFGEM (2014), ‘Consultation on a proposal to make a market investigation reference in respect of the supply and acquisition of energy in Britain,’ [‘Executive Summary’ – Pages 5-7, ‘Chapter 3’ – Pages 15-24 and ‘Chapter 4’ – Pages 26-33]. [Accessed 3 Feb. 2015]. Sloman, J. and Garratt, D. (2013).‘Essentials of Economics. 6th ed. Pearson. Financial Times Prentice Hall. p.Chapter 5. UK wave and tidal – swelling industry or risky business?.(2010). Renewable Energy Focus, 11(2), pp.4-6. [Accessed 3 Feb. 2015]. Warren, P. (2014), ‘A Review of Demand-Side Management Policy in the UK,’ Renewable and Sustainable Energy Reviews, 29. pp.941 – 95. Read More