The first of these models is the one favoured by the EU in its legislation and it was initially believed by some policymakers to be
the solution to Ireland’s problems. Under this EU legislation, any private sector firm can build a new generation station and find customers for their output. From February 2005 all customers are free to choose different electricity suppliers.51 It was originally
expected that lots of new entrants would build generating capacity and then compete for the favour of the roughly two million customers in the Republic of Ireland. However, this model suffered from a number of disadvantages.
Even with the business sector there is considerable inertia among customers. Even if electricity is on offer at lower cost from an alternative supplier, customers may be slow to shift allegiance. In the case of electricity the ESB “brand” is very strong – they have a reliable track record. This makes it difficult and expensive for new businesses to build up a customer base.
In addition, a single generator on its own cannot supply the commodity that consumers want – electrical supply that varies in line with the very different demand profiles of customers over the day. As a result, a single generator company will have to contract with other generators to provide these additional services that consumers want. Finally, individual generators can face huge costs buying in power to meet their contractual obligations to customers in the event of a breakdown in their own plant.
Given the scale economies in generation, new power plants involve major additions of capacity. However, as it takes time to build a customer base it potentially makes it difficult for new entrants to match supply with demand when a new plant opens. As an interim measure to deal with this the CER arranged sales of “virtual power” to potential new entrants. This meant that they could build a customer base in advance of opening. However, this remained a rather unsatisfactory mechanism for reducing uncertainty for investors mostly because independent power purchasing capacity was very difficult to acquire.
Probably the most serious problem with the current market is that new customers are not prepared to sign contracts for power supply with new entrants for periods longer than two or three years. This means that new entrants cannot guarantee themselves a market in advance of investing. As the capital costs in building generating stations are very large, this makes investment very risky, increasing the cost of capital. The normal way to finance a new power plant is to borrow with long-term contracts for sales of electricity providing security. This is not possible in the Irish case because of the impossibility of obtaining matching long-term contracts for sales.
The electricity supply sector is concerned with the purchase of bulk electricity on wholesale markets and the delivery of this electricity to customers. The metering of all consumers is handled separately. Supply is a distinct operation from the transmission and distribution system, which provides the wires to deliver the
51 Northern Ireland domestic customers will be free to choose their supplier from
electricity. This supply business accounts for around 5 per cent of the delivered cost of electricity so that it is a low margin business and it does not, on its own, provide much scope for efficiency gains from competition.
All of these factors make it very difficult for a new independent generator to enter the market through building a generation plant and developing a supply business through building its own customer base.
Significant uncertainty is also added because of the behaviour of the government as a player in the electricity market. The most obvious cause of uncertainty arises from government interference in pricing decisions by the dominant player, the ESB. In June 2000, the government announced a package of measures to combat inflation, including a commitment that electricity prices would not rise later in the year.52 This raised the prospect that new entrants would face
unfair competition in the future due to government’s use of its power as shareholder in ESB to restrict price increases. For the future new entrants should be protected from such behaviour by handing over responsibility for minimum as well as maximum prices to the CER.
A further major concern for new entrants is the fact that the ESB controls the bulk of generating capacity. By manipulating availability such a dominant player could potentially exert huge market power. Under government ownership the ESB has generally not acted to use its market power to maximise its profits. Instead it has generally acted as a public sector utility with a broad remit to act in the “public good”. However, the possibility that the ESB might be privatised in its present form raises the prospect of major future dangers for new entrants. This is an additional reason for making a clear commitment not to privatise the ESB in its present form. This issue of dominance and how it can be dealt with is addressed in the next chapter.
For all eligible customers (eligible to buy from any supplier) they will pay the current long-run marginal cost for generation, plus whatever charges are set for use of transmission and distribution systems. If a new entrant could undercut the ESB, the ESB would eventually have to react by matching that price for all categories of eligible customers; otherwise all eligible customers would move to new entrants, possibly resulting in substantial stranded capacity or stranded contracts. This would mean that the ESB on its own could no longer internalise cross subsidies to peat or wind generation and other social obligations. This has been reflected in the bundling of many of these costs into a new Public Service Obligation (PSO), payable by all consumers.
The result of these uncertainties is to greatly increase the cost of capital for new plant and to reduce the incentive to invest. This is a problem common to all electricity systems (Castro-Rodriguez,
52http://www.ireland.com/newspaper/finance/2000/0628/archive.
Marin, and Siotis, 2001). This market structure makes it safer and, therefore, more profitable for individual players in the generation market to under-provide rather than to over-provide capacity. The result of pursuing this model without offsetting measures to ensure security of supply could be significant shortages of generation capacity over the next decade. With a very low price elasticity of demand for electricity, this would translate into a major increase in prices and much bigger profits for incumbents. Clearly, from the point of view of the consumer, this is not a satisfactory prospect.