Vol 1 (2004) - Issue 2

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The Independent Power Sector - A Study in Distress

Introduction

In the thirteen years since the privatization of National Power and PowerGen, the electricity generation sector in the UK has probably undergone more radical change than any other. In 1991, three companies - National Power, PowerGen and British Energy - accounted for ninety per cent of all the electricity generated in England and Wales. A new set of trading arrangements based on a pool had been launched in April 1990. Major electricity customers were free to choose their own supplier of electricity but seventy-five per cent of the market was still obliged to purchase its electricity through the regional electricity companies (RECs), who also owned the local distribution networks.

From the outset, National Power and PowerGen sought to maximize profits by using the pool rules to their advantage. Under the terms of the pool, all generators received the marginal price of electricity in any half hour. The marginal plant was almost exclusively in the hands of one of these two generators. Consequently they had both the motive and the opportunity to push marginal prices higher. Fuel prices, which constitute the majority of a power station’s marginal cost, were relatively steady at the time. Hence, higher generation prices meant higher profits.

The immediate effect of this policy was to encourage a serious investment in new independent gas-fired power stations. Gas had not played a major role in the power generation sector prior to privatisation, when large nuclear and coal-fired stations had been the plant of choice. A plentiful supply of gas, coupled with the combined-cycle gas-turbine (CCGT) technology, meant that new gas stations were economically as well as technically efficient. The financial robustness of the first generation of new CCGTs was reinforced when the power plants became the beneficiaries of power purchase agreements (PPAs) signed with the RECs, who could use their retail supply monopoly to hedge the contracts.

The regulator (Ofgem) at the time encouraged these new power plants by allowing the cost of the PPAs to be passed through to customers. However, it was also clear that the benefit of pass-through could not be expected to continue once the retail supply market was opened up to full competition, then envisaged for 1998 but achieved in practice in 2000.

Restructuring of the generation market and the emergence of vertical integration

As generation prices remained stubbornly high, the regulator started to require the two generators, National Power and PowerGen, to dispose of plant. The first disposals were of 6000MW in 1996, all of which was purchased by one of the RECs, Eastern. The disposals were structured as long-term leases with part of the consideration in the form of output-related payments. Thus all three generators retained an interest in higher generation prices.

The Eastern acquisition established a precedent in the England and Wales market for vertical integration. The Scottish industry had been privatized in vertically integrated form (Scottish Power and Hydro-Electric). Maintaining the separation of generation from retail supply had been a key feature of the privatisation in England and Wales and this first move towards vertical integration by Eastern was to have significant repercussions.

The continuing high price of generation led to two further effects. First, promoters of IPPs became emboldened to finance new power plants without the benefit of PPAs - merchant power plants. Second, the regulator insisted on further disposals by National Power and PowerGen.

The context of these disposals brings the two strands of our story together. Both PowerGen and National Power were allowed to buy RECs provided they disposed of 4000MW capacity each. This culminated in the acquisition of EastMidlands by PowerGen and Midlands by National Power; while PowerGen sold Fiddler’s Ferry and Ferrybridge power stations to Edison Mission Energy without off-take contracts, and National Power sold Drax to AES with a partial off-take contract from TXU, who by then had acquired Eastern.