A break-up to help avoid a meltdown

The announcement that British Gas is to break itself up and that Cedric Brown is to step down as chief executive comes after one of the worst years in the company's history. In consumers' perception of utility services British Gas has slid from one of the top places to the bottom. It was among the worst-performing shares in the FT-SE 100 Share Index last year.

Although it is easy to blame managements, the problems at British Gas are in large measure a consequence of the way it was privatised and the actions of government. When the company was privatised back in 1986, the then Secretary of State for Energy, Peter Walker, opted for a monopoly. He believed in the "national champions" model, and had little sympathy for those in the Conservative Party who looked to competition and market forces to ensure efficiency. Having just seen Margaret Thatcher's government through the miners' strike in the winter of 1984-85, and with a powerful ally in the form of Denis Rourke, chairman of British Gas, Walker won out against the Cabinet opposition - noticeably from the Chancellor, Nigel Lawson. Peter Walker later joined the board of the privatised British Gas and is believed to have maintained his strong opposition to breaking up.

The core problem with the Walker-Rourke model only became apparent in the early Nineties, as industrial competition developed. As long as the monopoly over customers remained entrenched by law, the integrated approach to gas purchase, transportation and supply delivered a reasonable service.Under successive regulatory price caps, prices fell. They are now around 25 per cent lower in real terms than in 1986.

Competition is, however, a radical force. It has undermined the edifice. A Monopolies and Mergers Commissioninvestigation in 1993 suggested that there was an "inherent conflict of interest" at the heart of British Gas, in that it could not own the pipes through which its gas and that of its competitors flowed without unfairly benefiting itself. Competition required that all competitors had access to an independent network, which could only happen with a formal separation of the pipeline business (TransCo) from the public gas-supply part of British Gas. The MMC therefore recommended break-up.

That key recommendation was rejected by Michael Heseltine, by then in charge of energy policy as President of the Board of Trade. Enamoured, like his close former colleague, Peter Walker, of the "national champions" model, he preferred a rapid phase-out of the monopoly - but not break- up. The Gas Act was duly passed at the end of 1995.

What both British Gas and the Government appear to have failed to notice is that competition undermines the long-term contracts that British Gas had signed as a monopoly supplier. It had contracted for supplies well into the future on the understanding that it had a captive market on to which to pass the costs. In following the logic of the monopoly model, it had put itself into an uncompetitive position. The Gas Act, through competition, exposed British Gas to the consequences.

Those consequences have been financially disastrous for British Gas; this week's break-up is the belated response. Now, as recommended by the MMC, the pipes will be separated out as a necessary first step to meeting the competitive challenge.

The break-up is not, however, a "solution" to these legacy contracts. The new company's managers will still have to resolve the tricky problem of who pays. Separation will help to define the problem and focus attention on its solution. However, short of a rise in gas prices or a change of regulatory heart, the shareholders may still have to pay the price for having had the benefits and obligations of the monopoly.

When the dust has settled, the British Gas break-up will be seen in the wider context of the restructuring of the energy market. The electricity industry has seen a wave of takeovers and steps towards restructuring ahead of competition in 1998. Gas is simply following suit. Takeovers, mergers and break-ups will result in a much more complicated sector. More companies will compete, and the old certainties provided by the familiar one-stop shops will have gone. Competition has made this inevitable. It is a process that is far from complete.

Whether this is good for customers is yet to be shown. In the short term, prices can go in only one direction - downwards. In the longer term, however, when the surpluses of North Sea gas are gone and when fuel markets tighten, the results may be much less attractive than the immediate price cuts might suggest. Competition has only just begun, and it has done so in benign conditions of over-supply and cheap fossil fuels. It is yet to be tested in conditions of excess demand.

The break-up also has a political side-effect. The public concern over executive pay found a convenient scapegoat in Cedric Brown. He has borne the brunt of public anger and a scalp has finally been taken. But that single sacrifice will not solve the issues of corporate governance and public accountability to which privatisation has given rise. While British Gas's executives may now earn a respite, the questions raised will remain for the electorate at the general election. The future of Cedric Brown should not obscure the debate on the kind of energy sector that is emerging under market forces. This - not executive pay - is what will matter for the future competitiveness of UK plc.

The writer is Fellow in Economics at New College, Oxford.