ACrrYVlEW

Nigel Burton

Five years ago, prior to the White Paper which resulted in the UK electricity industry
being restructured, newly regukted and p8rUally prhmtWd, the EleCtrlW Supply
Industry and the City h d lW d i m Imorrkdg.Of UndW8tandlng at 8aCh Other.
P r h " U o n has fundanenblly churgod thb, .Ithough the relrtionrhlp and
undemtanding between industry and clty mubrr as immature as the Industry
structure itself. The Mure prospertty at tho Industry k likdy to depend upon the
ability of management team throughout the industry to idenWy and pursue a virion
which balancer the asplntlonr and the concerns at ail major Interest groups -
whether directon, m p l o v , ah,- Cwtomers, COmpetitorS,
commentators, regulators or pditldans.

The electricity supply industry (ESI) is, collectively, one of the largest wnstituents of the
domestic economy, with net sales equivalent to some 296 of gross domestic product
(GDP). However, until privatisation, ?he city. had l i direct knowledge or understanding
of the ESI, as individuals there and elsewhere simply took for granted that the lights stayed
on, without appreciating the p r o f e s s i s m and the investment necessary to achieve this.
Equally the industry had little direct experkme of the commercial world at large, having the
luxury of being a monopoly provider of an essential product with limited competition and
little more accountability than the occasional politicalnegotiation over investment plans and .
tariffs.
The significant restructuring of the industry and it's subsequent partial privatisation have led
to cost reductions and cultural change more rapid than could have been envisaged without
these changes. Wmout privatisation it is quite possible that as many as three 1,800MW
coal fired stations and perhaps three more PWRs might now be ordered or under
construction, that the political poliaes that hid the huge subsidies to the coal industry and
the true costs of nuclear power from the customers might still be in place, and that public
sector attitudes that customers were merely to be treated as consumers might still be
prevalent.

The C i ,for it's part, has begun to understand the size and dynamics of the ESI, has
invested in the shares of those compan'm which have been privabd, and has learnt to
value these companies, combining financial analysii with the ever-present need for political
-
and indeed regulatory understanding quite an achievement given the differences between
the structures in England & Wales, scatland and Northem Irelandl. Apart from the
institutional shareholders, and thek advisers in City s b c k b d* q and merchant banking
firms, the debt markets have also played a signmcant but less visible part in the
Dr Nbd Buton b H o d OtUm utlykr Tam, 8 0 W U k . 0 Ikwrltkr,1 Flnrkry Amnu& LONDON,
EC2M S A , ENGLAND. phocl.:+44 71 512 402a

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 restructuring of the industry. Not only has the banking system provided the faalities
necessary to cope with the enormous working capital and flows of funds in the industry but
it has also been responsible for funding all of the "independew power producers and
financing long term bonds for several industry participants.

Market perceptions

The valuation placed on the shares of the main industry partidpants (National Grid is
owned by the RECs and remains unlisted for the time being, Northem Ireland Electricity is
expected to be floated in June, whilst Nudear Eiectric and Scottish Nudear are likely to
remain state owned for the foreweable future) may seem curious,if not --cautious, at
first sight, althoughthere am good masons for this.

First, apparently paradoxically, the strong financial performance of all the industry
constituents, which has resulted not from prices above those expected but from
unanticipated cost reductions, has been seen as one of the major weaknesses of the
structure and regulation of the industry, leading predictably to allegations of excessive
profits. This strength, against the background of the worst post-war recession in the UK,
which has perhaps f a c i l i much of the cost reduction and cultural change, leaves
tremendous scope for far tighter price regulation to be Introduced, particularly in the
distribution review next year.

Second, since privatisationthe industry, in England &Wales in particular, has been subject
to a plethora of regulatory intenrentions and invest$stions , most examining aspects of the
electricity generation business. There was also a report from the Energy Select Committee
in February 1992, shortly before the General Ektion, which highlighted many of the
political prejudices and uncertainties w h i i pose risks to long-term investors and
participants in the industry. More recently the political furore over the proposed pit
dosures, which culminated in a Trade and Industry Select Committee report and a
Govemment white Paper on Coal have reinforcedthe dear message that the industry will
remain subject to political and regulatory uncertainties.

These two principal factors combine to suggest that the market valuation of the industry
constituents is indeed reasonable, and in effect summarises the City consensus that the
industry remains vulnerable to significant and unpredictable change, whether through
regulatory or political pressures, which could materially affed the profitabilityor structure of
any or all of the companies. The management challenge must indude, as a high priority,
minimising these risks wherever possible.

Own goals

Politicalintetventioncannot be prevented, although there is much the industry cwld do to

reduce some ofthe obvious factors hat are likdyto trigger politicel interfwence. For
example, although- major risksto the indusby posed by the'coal crisis' have receded,

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 the highly public intemedne warfare between different industry factions (most notably
those in the RECs who wish to reduce the power of the generators, but also the
generators' proposals to curb the IPPs) which was most evident during the review remains
harmful to all of those whose prosperity and security depends upon the industry. Similarly,
the failure to collate and disseminate the facts about electricity prices has allowed the
notion that privatisation has brought higher prices to become firmly established both in the
UK and overseas, whilst persistent reference to the 26GW or so of new connection
agreements by NGC has provided the opportunity for those who prefer central planning,
are opposed to change to ridiwle the 'British EqWmetV. The effect of t his within the UK
is obvious, whilst overseas it presents opportunities to undermine the credibility of the UK
ESI with their own politicians in an attempt to protect their own positions or to discourage
competition from UK u t i l i in countries where they wish to expand themselves.

Thus the industry seems unable to put fotward COMistent and coherent messages about
-
the benefits of the new industry structure induding those to the customer. The water
industry, through the Water Services Assoclabon
* ,has managed to do this despite the very
-
separate nature of the old industry st" surely the elecMclty industry, perhaps
through the Electricity Association, should be doing the same ?

Qui custodiet ipos custodes 3

The unpredictabili of political intervention is, if anything, better understood than the
prospects for regulatory intervention. The question Qui custodiet ipsos custodes ? (who
regulates the regulators ?) is hardly novel, but has become increasingly topical in the last
year, with numerous comments, predictions and calls for action from academics, British
Gas,BT, joumalii and others.
The principal focus of attention is the apparedy increasing divergence of regulatory styles
between regulators, with the accusation from some quarters that companies risk 'creeping
regulation' and increasingly frequent intenrention as individual regulators exercise their
considerable personal discretion in interpreting their duties, with the implication that they
pursue their own objectives which go beyond either the spirit or the letter of their formal
duties. Ironically Professor Stephen Littlechild, the one regulator that (in his evidence to
the Trade and Industry Select Committee) indicated that he would not interfere in issues
outside his jurisdiction was heavily critic$ed by the Committee, whilst both Sir Bryan
Carsberg and Sir James McKinnon have evidently received official approbation and
recognition of their services.

The lack of transparency in the regulatory system is probably of greater concem to the
investment community. Despite their professed concern about transparency the regulated
businesses seem content to (prefer to?) conduct much of their discussions with regulators
-
in private indeed to date it has been the regulatots that have been proacthre in publishing
consuttative dcmments on various features of regulation, with the companies then
responding. This is one ofthe many areas where the imrestors viewshave,todrrte,been
ignored by the industrywhichseemsto believethad it can achieve a better regulatory deal

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 through secret negotiations than by allowing at least the principles underlying the
negotiations to be aired publicly. This is unfortunate because, in one of the most widely
read texts on regulation published in 1989 (The Regulation of Privatised Monopolies in the
United Kingdom, Beesley &?Littlechild, Rand Joumal of Economics), Professor Stephen
Littlechild explained that two of the four prinapal benefits of the RPI-X style of regulation
were the degrees of freedom open to the regulator who "canmodify (at least at the margin)
any aspect of the framework' and that 'the UK regulator has more discretion and less need
to reveal the basis of his decisions than does his US counterpart.' This demonstrates all
too clearly why investors are right to be a " d over the accountability of regulators -
although they should perhaps have made their C(XICB(TIS dear before flotation rather than
after.

This lack of accountability perpetuates one of the worst aspects of the previous
nationalised industry, where clearly uneconomic dedsions were often made on a political
whim. The uncertainty which this urnwmntd discretion and poor accountability
engenders must be reduced, as it makes "gmmt unnecessarily difficult, investment
-
less certain, and costs probably higher than they otherwise could be metering being the
most readily understood example.

Structure of the industry

It was atways unrealistic to assume that the structure and regulation put in place prior to
privatisation would provide a perfect and instantaneous solution (Rome wasn't built in a
dayl), thus further change in the industry seems likely.

Traditionally it was assumed that vertical integration would be the most natural trend within
the industry. However, apart from the specific restrictions on the RECs limiting ownership
of generation, it is not at all dear that heightening exposure to a single political and
regulatory system makes strategic sense. Similarly it is unclear whether the generators
would be wise to extend their activities by acquisition of RECs, as even their forays into
second tier supply (2TS)have raised worries over cross-subsidisation.

Horizontal integration, or mergers, might also seem logical, although probably not until
after the supply and distribution reviews are completed in 1993 and 1994 respectively. It
would be worth noting however that hostile bids within the industry are unlikely to succeed
whilst agreed mergers, whether with other electricity companies, with other utilities or
indeed with other industrial partners, would not change the structure or regulation of the
-
industry significantly although a successful bid from outside the industry for one of the
companies could galvanise other companies in the way that privatisation itself has already
done.

A more likely change is the restructuring of generation ownership, normally a euphemism

for breaking up National Power and/or POwerGen, a favourite hobby horse of those
fighting both old and new battles. The Regulator will consider not later than 1W5whether a
reference ofthe majorge"t0the MMC is mwssaty, following recommendrrtions of

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 -
the former Energy Select Committee it may be as well for the generators to pre-empt the
risk of an enforced break-up by doing it themselves as the Regulator 'will take into account
the development of the major generators' costs and profit margins and the development of
the companies' policieson the disposal of plant in reaching this judgement.'

A reduction in the unhealthy over-emphasis on The Pool would be a significant step

towards a more stable market, and one that has received support from customers,
politicians and the Regulator, albeii not always for the same reasons. Nevertheless in the
absence of an actively traded public market in electricity contracts or the introduction of
new mechanisms such as contracted power Rows, and a reduction in the subsidies and
distortions remaining in the electricity market, it is unclear how t
hiscan be achieved.

Condusions

The industry, and its C i shareholders, have benefited significantly from privatisation.
Much of the turmoil and instability manifesting itself is only to be expected as the inevitable
consequence of the change from a centrally planned "liked industry to the private
-
sector model chosen the symptoms of an underdampedsystem are obvious, suggesting
that the transition could have been managed differently.

Market perceptions and valuations remain dominated by the risks of further political and
regulatory pressure on the indusby. The new industry structure is not immutable, and the
greatest challenge will be for the industryto act both individually and collectively to reduce
these risks, rather than continuingits unedifying internal conflicts in public. A more outward
looking approach is nec~ss(vyto counter the well publicised shortcomings of the
regulatory system, and to improve the image of the industry in domestic and overseas
markets where such significant opporkrnitiesexist.

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