PowerGen Plc and Midlands Electricity Plc: A report on the proposed merger

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Summary

This inquiry involves the proposed merger between PowerGen plc (PG) and Midlands Electricity plc (MEB) which was announced on 18 September 1995. We find that the proposed merger qualifies for investigation.

The electricity industry in England and Wales consists of four elements: generation, transmission, distribution and supply. Generation capacity is currently about 60 GW. The supply market is divided into two parts each with about 50 per cent of total sales by volume: supply of customers with power requirements over 100 kW, which is competitive; and supply of under 100 kW customers. The latter market is served by 12 Regional Electricity Companies (RECs) each of which currently has a local monopoly. This market is due to become competitive in 1998.

PG is the second largest generation company in England and Wales with a current market share of 24 per cent by output. It is also the largest supplier in the competitive part of the supply market, with a 16 per cent share of this market by volume. MEB is one of the 12 RECs and, like the others, the sole distributor of electricity within its authorized area. In addition to its supply monopoly in the under 100 kW part of the market in its own area, it has a 6 per cent share of the competitive supply market in England and Wales as a whole. MEB also has generation interests, chiefly as a minority shareholder in two independent power producers (IPPs), with a total capacity of 2.7 GW.

With a few minor exceptions generators sell their electricity into an Electricity Pool. Suppliers buy from this Pool. Generators bid into the Pool the availability of their plant and the prices at which they are prepared to generate. A Pool purchase price is derived for each half-hour of the day from the bid price of the most expensive generating set that is required to meet forecast demand for that period, enhanced by a capacity payment. All generators called to generate receive this price.

Because Pool prices fluctuate, generators and suppliers enter mutual hedging contracts called Contracts for Differences (CfDs) which typically involve an agreed strike price for a specified quantity of electricity and a specified period of time. Payments are made between generator and supplier to cover differences between the Pool and strike prices.

The generation market is becoming less concentrated. At the time of the reorganization of the electricity industry in 1990 the two largest generators, PG and National Power PLC (NP), had between them 73 per cent of the market by output. That figure is now down to 57 per cent. The change has been chiefly brought about by new entrant IPPs (now 10 per cent of the market) and an increase in the output of nuclear plant. We expect these trends to continue. PG and NP have agreed with the regulator to sell 2 GW and 4 GW of plant respectively. Some 2.8 GW of new capacity owned by IPPs is due to be commissioned in 1996 or is under construction. We expect that these and other developments will reduce PG's market share to around 17 per cent, and PG's and NP's combined market share to around 38 per cent over the next few years. This will provide a broadly satisfactory competitive environment in generation from 1997 onwards in the absence of the merger.

Generation is divided into baseload, which we define as continuous operation, and non-baseload, which involves plant being turned on and off to meet variations in demand. Plant operating at non-baseload sets the Pool price for most of the time. In 1995/96 PG's share of non-baseload output was 41 per cent. As a result of new entry, and of there being more base-load capacity than demand, which will push some existing baseload plant up into non-baseload, we expect PG's market share of non-baseload to fall to between 27 and 30 per cent by 2000/01.

As a consequence of PG's share of non-baseload generation, plant owned by PG has historically set Pool prices for a large proportion of the time (about 35 per cent in 1995/96). As competition in generation increases we expect that, in the absence of the merger, PG's ability in future to affect the level of Pool prices for a sustained period, whether to keep them high or to cause them to fluctuate, will be small.

We consider that the acquisition by PG of MEB's equity interests in IPPs as a result of the merger would give it influence over and information about the operation and future development of these IPPs, leading to a reduction in competition and causing prices to be higher than they otherwise would be. We also consider that PG would obtain influence over and information about these IPPs through MEB's power purchase agreements with them, which would reduce competition and cause prices to be higher than they otherwise would be.

It has been put to us that the merger would reduce the size of the CfD market, making entry by both independent generators and independent suppliers more difficult. We agree that a small CfD market would inhibit entry. However, we believe this market will be larger in 1998 than it is now even if the merger proceeds and that it will be in the interests of both the generation and supply businesses of the merged company to continue to contract with third parties. That the CfD market after 1998 would probably not be as large as it would be without the merger is, in our view, unlikely to lead to effects adverse to the public interest.

The merger would reduce from 16 to 15 the number of major players in the over 100 kW supply market. This market is a highly competitive one and we do not think that the loss of MEB as a competitor will make a significant difference to the level of competition. Two opposite views were put to us about the effects of the merger on the under 100 kW market from 1998. One was that it would reduce competition by removing MEB as a competitor. The other was that it would increase competition by creating a more aggressive competitor. We do not believe the merger would reduce competition in the under 100 kW supply market.

Other possible adverse effects of vertical integration were put to us including the ability of an integrated company to pass through higher generation costs to customers. We do not believe an integrated company would have any greater ability to charge higher prices to customers than an independent supplier. Nor do we believe the integration of PG's generation business with MEB's distribution business is likely to have adverse effects.

The merger would make it more difficult for the Director General of Electricity Supply (DGES) to monitor and enforce license conditions such as prohibitions on cross-subsidy and discrimination, and the requirement for economic purchasing. The merger would give rise to uncertainty about the ability of the DGES to prevent PG from jeopardizing the ability of MEB to finance its activities. It may be expected also to result in some customers unwittingly giving up rights deriving from the Electricity Act and the Public Electricity Supply (PES) license.

The merger would have the benefit of creating a company better able to compete in international markets because of its increased size and wider range of skills and experience. We consider that this benefit is not sufficient to outweigh the adverse effects of the merger.

We conclude that the merger may be expected to operate against the public interest.

We do not consider that the adverse effects of the merger are sufficiently serious to justify its prohibition. However, we recommend that it should only be permitted to proceed if undertakings are provided by PG and MEB as follows:

- that MEB's equity interests in IPPs will be disposed of within 18 months;

- that information arising from MEB's power purchase agreements with IPPs will be ring-fenced within the merged organization so that PG's generation business has no information about or influence over these IPPs; and

- that license amendments will be agreed to assist the DGES effectively to monitor and enforce license conditions; to ensure that businesses carried on by MEB under its PES license are kept separate from other businesses carried on by the merged company and that resources for the former are available; and to require the merged company to inform tariff customers in MEB's area, before agreeing to supply them under PG's second-tier license, that they would not have certain rights under the Electricity Act and the PES license.

One member of the Group agreed with our findings on the public interest but disagreed with several of our conclusions and with our recommendations. Her reasons are set out in a note of dissent.

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