Liberalisation of the gas market in the UK

Liberalisation of the domestic market is still comparatively recent, and competition lags behind the industrial and commercial sectors. However, the rate of ‘take-up’ (i.e. of customers choosing to take gas from a new supplier) has increased, and the supporting IT systems have worked well.

This take-up rate has also been significantly faster than in telecoms, where the domestic market has been open to competition for several years. 

WHY WAS IT DONE?

The reason for liberalisation was to benefit both industry and consumers by introducing competition. Gas prices are 20%-50% less than they were at privatisation, and are now among the lowest in the world.

One of the factors that influenced the decision in 1993 to go for a bold liberalisation programme in the domestic market was the knowledge that the supply position was favourable. Downward pressure on price levels, arising from the inevitable unwinding of cross-subsidies as competition was introduced, was already evident. A similar opportunity may now be available in mainland Europe.

Other factors included a report by the Monopolies and Mergers Commission in autumn 1993, which found the integrated structure of British Gas to be against the national interest. Domestic political factors were also favourable. The government had been re-elected in 1992 and, like most governments in their earlier years, was prepared to contemplate more radical measures.

HOW WAS IT DONE?

The initial legal move to abolish the British Gas monopoly for very large consumers was made in 1982. In 1986 British Gas was privatised as an integrated monopoly, and the consumption level below which BG had a monopoly was reduced. In 1992 this level was further reduced to 2500 therms, so that the competitive segment covered virtually all industrial and commercial consumers, and some large residential households.

Yet even then competition did not grow naturally. The concept of each successive ‘liberalising’ measure since 1982 had been to provide rights of access to the BG pipeline system to competing companies. But BG remained an integrated company, and its natural incentive was to discourage new entrants from competing against it. Moreover, BG had contracted for all gas available from UKCS fields, and use of the only import facility at that time (the Frigg pipe-line from Norway) was subject to a protracted negotiation between the British and Norwegian governments. 

Increasingly strong regulatory measures were taken to try to stimulate competition. These included a prohibition on BG from purchasing more than 90% of gas from ‘new’ fields, a gas release scheme to oblige BG to transfer gas to competitors, a market-share ceiling imposed on BG, and a requirement for BG alone to publish price schedules.

However, it was felt that such draconian regulatory action was not the way to establish a healthy competitive market. A structure where regulation could work with the natural incentives of the market instead of against them was preferred.

MMC REPORT 1993

The culmination of the investigations into the gas market came in 1992 with a request to the Monopolies and Mergers Commission to examine the whole structure of the industry. The MMC recommended an enforced break-up of BG between its transportation and trading activities. Anticipating that this would take some time and cause transitional problems, the MMC recommended a slow opening of the domestic market to competition, on a phased programme up to 2002.

The key to success was to identify the natural monopoly element in the system, and to structure the industry in such a way that this element was separated out and regulated as a distinct entity. All other elements could then be made competitive as fast as possible. Regulation would, of course, remain for the monopoly elements of the industry.

The monopoly activity has thus moved outside the chain of contractual relationship leading from the initial gas producer to the final consumer. This chain is now competitive at each stage. It consists of four principal links.

  1. The producing sector, which has been competitive for many years (by contrast to the generating sector in electricity).
  2. The shippers, essentially aggregators or facilitators, who arrange to convey gas on behalf of a supplier from the processing terminals through the pipeline system to a customer’s premises. This sector is now fully competitive.
  3. The competing suppliers, who are the retailers selling gas to the final consumer. Some of these suppliers are also shippers.
  4. The final customers, whether power stations, industrial or commercial companies, or domestic households.

The monopoly pipeline provider’s point of contact with the chain is through the shippers, who contract with the pipeline company to have their gas conveyed through the system. The pipeline monopoly has no direct contractual relationship with final consumers, however – a key difference from the old system.

It happens that the pipeline system is owned and operated by British Gas, but it could easily be under quite different ownership. In the food industry, for example, which the gas industry now resembles in having a fully competitive chain between producer and consumer, the major food distributors do not expect to own the road system.

TRANSPORTATION, SHIPPING AND SUPPLY

The distinction between the three basic activities in the UK system is important.

‘Shipping’ does not involve the physical activity of transporting gas. It is the administrative activity of arranging for gas to be transported and delivered at premises specified by clients (suppliers). The skills are those of trading, aggregating, and taking advantage of all the different facets of the transportation charging regime.

‘Supplying’ is a purely retail activity, and the skills required are those of marketing and serving large numbers of customers. Many of the new suppliers in the market have no direct experience of the gas industry, but they are experienced in the skills of serving a large customer base (for example electricity companies and supermarket chains).

The general term ‘trading’ describes the collective activities of shipping and supplying, and distinguishes them from the activity of ‘transportation’.

‘Transportation’ is the activity of physically transporting gas through pipeline systems. In the UK this covers high, medium and low pressure systems, which are required to be exclusive monopolies by geographical area.

Great Britain is a confined, densely-populated place and the introduction of competing pipe-line systems would present much greater physical difficulty than, for example, in Germany where competing systems are encouraged as a means of promoting competition. The national natural gas pipeline network was built by British Gas Corporation in the late 1960s. It is of high quality and highly ‘looped’, ie comprising a number of alternative routes between points. It would be uneconomic to construct rival systems, and no provision for competition in this sector was included in the 1995 Gas Act.

Now that BG’s interest is confined to transportation, it wants to encourage the growth of competition among shippers and suppliers, since this is good for its own business. For example, in 1997 Ofgas and the DTI wanted to accelerate the provisional timetable to start competition in the domestic market in Scotland and North-East England. BG Transco willingly came up with the detailed scheme enabling this to be done.

Of course, British Gas Trading (Centrica) still has the natural incentive of the dominant supplier to restrict and defeat competition from new entrants. This is a formidable regulatory problem – but a more manageable one than trying to regulate a former integrated monopolist allowed to remain active in all segments of the market after competition is introduced.

METERING WILL BECOME COMPETITIVE

Initially the monopoly element of the industry was defined as the transportation sector in general – the operation of the pipeline system and of certain ancillary services such as storage and metering. But this definition is by no means fixed. Storage has already been moved into the competitive sector, and there are plans to do the same with metering and metering services. New connections and extensions to the pipeline system were made competitive at the outset.

Competition in shipping through the common pipeline system is made legally possible by providing rights of access to that system by companies other than its owners – essential to creating a competitive market.

Up until 1993 it was assumed that the legal provision of such rights was sufficient to establish a healthy competitive market. The same view underlies the principles of the 1998 European Gas Directive. It appears, however, that the provision of third party access rights is a necessary but not sufficient condition for creating a successful competitive market.

To be effective the provision of third party access rights must include at least the following:

  • A right of access on non-discriminatory terms.
  • Provisions to ensure that the charges for access are as low as is consistent with providing an efficient, reliable and safe system; that they are non-discriminatory; and that the pipeline company does not exploit its dominant position.
  • A provision to ensure that the pipeline company meets all economic demands made upon it, including expansion of capacity.

Additionally, it is desirable to place a specific obligation on the pipeline company to promote competition in the use of its system. All these provisions can be found in the new UK regulatory structure, either in the new Gas Act itself or in the conditions of licences issued to gas transporters.

THE LEGAL INSTRUMENTS

There are three principal legal instruments which provide the framework for the competitive market – the Gas Act, the licence conditions of companies operating in the industry and the Network Code.

THE GAS ACT 

In 1994 the decision was taken to amend the Gas Act to provide a suitable framework for competition. (This approach differed from the decision taken by the electricity regulator, which decided to try to extend competition within the existing legal framework.) The old British Gas supply monopoly could have been abolished under existing legislation, but this would have meant setting up a competitive market within a legal framework designed round the concept of an integrated ‘public gas supplier’ with other suppliers licenced under a different category. The new Bill came into force on 1 March 1996.

THE LICENCE CONDITIONS

The new Act specifies three separate types of activity for which a licence is required – gas transporting, gas shipping and gas supplying. The same legal entity may not simultaneously hold a transportation licence and a licence to ship and/or supply.

Licences are granted by Ofgas. The Act requires that standard licence conditions, determined by the Secretary of State, are incorporated into licences. Ofgas has powers to modify these standard conditions, and may also impose special conditions in individual licences.

THE NETWORK CODE

The Network Code governs the use of the pipeline system of each public gas transporter (PGT) by competitive shippers. BG Transco is the largest PGT and the term ‘the Network Code’ is usually a reference to the code governing use of the BG pipeline system, although there are codes covering use of smaller PGT systems.

The Code is regularly modified in the light of experience, under the supervision of Ofgas.

FUTURE DEVELOPMENTS

The next period will determine how quickly competition becomes established. This will be a critical period for firm regulatory action to get the right balance between new entrants and the incumbent former monopolist. Regulatory pressure to move more of the present monopolistic activities into the competitive sector will continue. 

Meanwhile the UK government has initiated a review of the regulatory system itself. It has endorsed the principle of independent regulation, but has suggested that regulators consider some modification to the standard UK ‘incentive regulation’ RPI-X price control formula, to ensure that regulated companies do not make ‘excessive’ profits. Some increased powers for ministers to give guidance to regulators on such matters as the government’s views on environmental and social policies are also proposed.

The government now intends to create a legal separation between the activities of electricity supply and distribution, following the model of the new gas industry structure. 

THE ROLE OF OFGAS

Ofgas is the independent gas regulatory office, set up in 1986 when BG was privatised as a monopoly. Its principal functions are:

  1. To continue to regulate the monopoly or dominant elements in the gas industry. 
  2. To work actively to increase the scope of competition in the industry. 
  3. To act as a competition authority for those parts of the industry that are competitive.

The transportation segment of the industry is likely to remain monopolistic, and therefore remain subject to economic regulation by Ofgas. However, as competition develops in the rest of the industry, the emphasis of Ofgas’ activity will be focused on the second and third items. 

Economic regulation of the industrial and commercial supply market, now fully competitive, has ended (for example there are no longer any price controls). However, the domestic market is in a transitional state between monopoly and competition, and economic regulations are still in force for the time being. 

Licence Conditions

The source of Ofgas’ authority is the statutory ability to impose and enforce conditions on the licences that are required by companies involved in gas transportation, shipping or supply. The standard conditions of suppliers’ licences in particular contain a number of ‘social obligations’ required by the government, including obligations to offer special services to old, blind or deaf people, and provisions restricting the ability of suppliers to disconnect, especially during winter.

Enforcement of these conditions is likely to be a continuing function of the regulator after competition is established. The Gas Act provides powers for the regulatory office to order compliance with licence conditions and to impose penalties, including fines. Ofgas’ method of working is non-formal and non-legalistic. There is no provision for semi-judicial public hearings, as in the US. The office can act on its own initiative; it is not required to wait until a case is brought before it. Thus decisions can be taken quickly in response to the development of a commercial situation.

The regulatory office is also independent of all commercial parties and of the government – something which is often viewed by other countries as controversial. While it may not be essential, it has had significant beneficial effects in the UK. Independence means that the government is no longer able to introduce short-term political factors. Acting independently, the regulatory office is focused on the interests of the industry and those who consume its product. It can take a longer-term view and build up appropriate expertise.

This independence is subject to a careful set of checks and balances. The appointment of the director general is made by the government and is time-limited, usually for five years. Although the director general has full regulatory discretion, this must be exercised in accordance with statutory duties laid down in the Gas Act.