Sparks to fly in electricity shake-up

WHEN PETER Mandelson returns to his desk in Victoria Street this week, he will find an issue needing urgent resolution. This is the small matter of the future of Britain's power industry and the fate of Britain's 15,000 coal miners.

The Secretary of State for Trade and Industry will have to reconcile conflicting demands. The Government is committed to free competition and free markets. While electricity privatisation has delivered handsome gains for shareholders and inflated boardroom salaries, it has not brought cheap power to British industry or the consumer.

Margaret Beckett, Mr Mandelson's predecessor, proclaimed in June: "There are serious distortions in the electricity market. Prices for consumers have been higher than they should have been."

A City analyst, who did not wish to be identified, was blunter: "The generators have abused their market power to push prices where they wish."

Everyone agrees that will have to change. How to do so, without destroying the British coalfields, is Mr Mandelson's problem. Gas is driving coal to the wall. It is cleaner and cheaper to burn gas; the gas-fired stations generate electricity up to 20 per cent more cheaply than Britain's aged coal-fired stations burning British coal. To sustain the stations in the longer term will involve fitting desulpherisation equipment.

That will cost a great deal, for no financial return. It is over a decade since anyone built a coal-fired plant. On current trends, a free power market can only hasten the end of British deep-coal mining.

Yet even for a man said by the Prime Minister, Tony Blair, to have balls of steel, laying waste to South Yorkshire represents a problem. Even as Mr Mandelson enjoys the last rays of Italian sunshine, his aides are already hinting at compromise. Yet it will be tough to satisfy all parties - the power generators, distributors, suppliers, customers, Richard Budge at RJB Mining (the flagship of the British coal industry) and South Yorkshire.

Meanwhile, the City is watching and waiting. Mr Mandelson has to restructure the industry for the foreseeable future, which will unleash a further wave of billion-pound takeovers in Britain and the US. Real money is riding on the outcome.

Officially, there are two separate decisions to be made. One involves ruling upon the pounds 1.9bn takeover by PowerGen (Britain's third largest generator) of East Midlands Electricity (the third largest electricity supplier, or REC). The other involves the energy review initiated by Mrs Beckett that is being completed by the Office of Fair Trading. The former decision is expected within a fortnight, the latter by the end of September.

In practice, the one implies the other; one will determine how British power companies have to be structured to ensure competition, the other will determine how they will compete.

Fortunately for Mr Mandelson, Mrs Beckett has already paved the way for a face-saving compromise. Her consultative document of 25 June fudged the issues nicely. It castigated generators, criticised the existing market mechanism, bemoaned the loss of diversity and the dash for gas.

Although foreign gas threatens to account for 70 per cent of the British market by 2020, Mrs Beckett insisted: "There is no question of guaranteeing market share for any fuel."

Despite this, Mrs Beckett moved to protect coal while cutting electricity prices. A moratorium was placed on consents for new gas stations "while our reform agenda is addressed."

Meanwhile, she proposed scrapping the electricity trading system and forcing the generating behemoths - PowerGen, Energy Group and National Power - to sell off capacity. These measures are intended to reduce their power and encourage new entrants and would, at least, eliminate the market skew against coal but would not make it cheaper.

Price has really begun to matter. Electricity is following the pattern set by other privatised utilities. After a glorious period of weak regulation, windfall profits, soaring shares and hefty bonuses, privatisation is finally bringing competition. The consumer was supposed to be able to chose his electricity company from 1 April 1998. Now it will be 1 April 1999.

Until now, Britain has protected its generators through the electricity pool, a market of sorts. Only the generators seem to understand how it works and they can manipulate it freely. French electricity imports, power from nuclear plants and new gas-fired plants have been priced according to marginal capacity from expensive coal-fired plants owned by PowerGen and National Power.

By meeting demand fluctuation, they set the price for the whole market. They have done this for nearly a decade, using coal to make the consumer pay over the odds for all electricity.

Significantly, the introduction of cheaper gas-fired capacity has not reduced prices. In June, some eight years after becoming electricity regulator, Professor Stephen Littlechild admitted: "A more competitive market would be characterised by significant decreases in generation prices. The ability of the two major generators [PowerGen and National Power] to prevent such decreases, demonstrates an unacceptable extent of market power."

Mr Littlechild is stepping down in October, together with Clare Spottiswoode, head of Ofgas. They are being replaced by one energy super-regulator, widely rumoured to be Callum McCarthy, a former civil servant and merchant banker. He will be confronted with a new electricity market, greeted with enthusiasm by the generators, and with caution by consumers.

This three-tiered market will reduce the electricity traded and priced in the short-term; most power will be subject to longer term contracts, leaving a smaller 24-hour spot market and a four-hour balancing market, designed to ensure the lights do not go out.

Like the stock exchange and unlike the pool, this is a buyer's market, where customers bid to buy electricity. Although the scope for abuse is reduced, the power of the big generators will remain. As one analyst observed: "There will always be intense demand for marginal capacity. Who has that capacity? The large portfolio players should always be able to make money out of any system."

To curtail their power and improve the prospects for coal-fired energy, Mrs Beckett proposed forcing generators to sell capacity to new entrants. Ed Wallis, the combative chairman of PowerGen, responded aggressively by buying East Midland and putting 4,000 megawatts of its 10,000 megawatt electricity capacity for sale, with a price tag of pounds 1bn.

There is no shortage of buyers. Should this deal receive the nod from Mr Mandelson, Mr Wallis will have set the pattern for the future.

The large generators - apart from British Energy's nuclear stations - will have their output capped at 6,000 megawatts. They will strive to offset the loss by combining supply with generation, and becoming more consumer-driven and more price-competitive.

Mr Wallis says: "We are creating the leading integrated UK electricity and gas business."

Both Scottish Power and Energy Group are already vertically integrated. National Power is clearly less eager to sell capacity, but if forced to do so, will inevitably be keen to buy an REC or two. Scottish Hydro Electric has admitted it wants to do just that.

Cynics might feel that vertical integration may just be a way of transforming a national monopoly into a local one such as that enjoyed by Scottish Power. That company has used its regional dominance to expand south of the border and now supplies one in five customers in Britain. Yet it is also a fan of the new, freer market, not least because it is cut out to be a winner.

"There are going to be a small number of large players, together with a few regional supply companies. The bigger the customer base, the lower the costs of servicing the individual account," says Colin McSeveny, of Scottish Power.

The fact that the domestic customer will be able to choose supplier should ensure prices fall. Following changes to the market mechanism, Mrs Beckett predicted wholesale prices will fall by 10 per cent in the medium term. "We believe the savings will not be as dramatic as those seen on gas. We expect prices to fall by 5-10 per cent," cautions Mr McSeveny.

The savings will be larger - 17-18 per cent - on a combined gas and electricity bill, which will have lower collection costs.

Combined fuel bills look set to sweep the domestic market, resulting in major consolidation of fuel suppliers. Centrica, once part of British Gas, sells electricity, while Scottish Power, PowerGen and many local RECs sell gas. Nifty marketeers such as J Sainsbury and Virgin look sure to enter the market.

The trend has already resulted in the creation of the power regulator; it is inevitably going to result in merger and takeover activity, too.

Clarity over the structure of the British market will help keep merchant bankers busy. Merrill Lynch foresees some British utilities becoming "world- class players" as they buy in the US. PowerGen's pounds 10bn merger with Houston Industries, a Texan utility, has had to be shelved until Mr Mandelson agrees to the East Midland deal. Several US deals, such as Scottish Power's bid for Florida Progress or PowerGen's acquisition of Cinergy, failed on price. Many mergers, where no premium is paid for control, seem likely.

The argument for creating Anglo-American utilities such as Energy Group, part of Texas Utilities, is simple. The British know about increasing plant efficiency and operating under deregulation; the Americans are marketeers. That is the view of PowerGen's Mr Wallis.

However, some of his American counterparts are no longer convinced; many of the seven US companies that bought RECs since 1995 are now disillusioned and looking to sell. Even so, the whole sector looks set to be swamped by deals.

For Mr Mandelson, the burning political issue is coal. Since the long- term contracts with PowerGen and National Power are now at an end, RJB Mining is facing a 40 per cent drop in annual demand from 25 million tons to 15 million tons. It is threatening to cut 4,000 out of 9,000 jobs, although its current plight has been eased by a surprising increase in demand for coal in the first half of the year.

Unlike Energy Group and National Power, PowerGen has yet to sign contracts with RJB Mining. The takeover of East Midlands gives Mr Mandelson the chance to strike a deal on new coal contracts which would secure RJB's medium-term future.

Provided that coal ceases to determine the price of all electricity generated, prices should fall far enough to keep the consumer happy. The higher prices caused by coal could be justified by a vague energy policy supporting diversity of supply.

Assuming enough coal-fired plants remain open, the issue can be heaved beyond the next election. Over to you, Peter.