Essay Example on UK Energy Industry

Energy is composed of potential and kinetic energy. Potential energy is a type of stored energy and includes chemical, mechanical, and gravitational energy while kinetic energy is found in movement. Energy at the United Kingdom as at the year 2014 stood at 2,249TWh which equate to per capita power consumption of 34. 82 MWh. Energy in is mainly supplied by the big six companies who have more than 90% shares in the industry. They provide gas and electricity to over 50 million business and homes in Britain. These big six companies comprise of British Gas, EDF Energy, Npower, E.ON UK SSE and Scottish Power (Cohen & Mazzeo,2007).

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However, since 2009 there have been several new entrants into the UK energy industry. They include Affect Energy, Avro Energy, better energy, Bulb Energy, Bristol Energy, Ecotricity among others. The big six has always been at the heart of controversies because they use their high level of control to raise prices unfairly. In 2014, Ofgem referred the UK energy market to the Competition and Market Authority (CMA) because of declining trust in energy providers and concerns about increasing prices. The CMA investigated concerns raised about factors that prevent and distorts competition, and in July 2015 they found that the households using the big six standard variable tariff could have saved up to 160 Euros a year if they switched to the cheaper external tariff with the smaller independent provider. CMA also the big six have considerable market power over their customers due to their pricing strategies which led to the two-tier energy market. The smaller tier which is the active consumer market and very competitive and a larger level which is inactive customer market which almost all clients are on standard variable tariffs (He & Reiner, 2015). The gap created by these two tiers were about 260 Euros a year as per 2015 as shown below;

Two tier gap

Types of Market Structures

There are four main market structures. These are a monopoly, oligopoly, monopolistic competition and perfect competition. Monopoly is a market structure which is characterized by a single firm controlling the entire market. The monopoly companies can reduce output and subsequently increase prices for more profit because of their high level of market power. Monopoly firms characteristics include they can set price; only one company dominates entire market, high barriers to entry and exit and they maximize profit. Monopoly firms have to be thoroughly regulated because they are not worthy in the sense that they result in lower outputs and high prices. Oligopoly is the second type of market structure. This entails a structure where it is dominated by only a small number of firms. The oligopoly firms can use their collective market power to raise prices and increase profit because of the ability to compete against each other or collaborate thus limiting competition. Oligopoly firms are characterized by barriers to entry and exit, products are either homogeneous or differentiated, they can set price, all businesses maximize profits, and lastly, there are only a few firms controlling the market.

Monopolistic competition is another type of market structure where a large number of small firms compete against each other. They sell similar but differentiated products which give them market power to set prices within a given range. Firms in the monopolistic competition are characterized by free entry and exit, firms sell differentiated products, consumers may prefer one product over another, and all firms maximize profits. Cereal market is a classic example of monopolistic competition firms. Lastly, perfect competition is a type of market structure where a large number of small firms compete against each other. The whole industry produces the optimal level of output because the single firm doesnt have any market power over others. Firms in perfect competition are characterized by free entry and exit to the market, no consumer preference; all firms sell homogenous products, and they all maximize profits. Stock markets is a classic example of perfect competition (Cohen, Glachant & Soderberg, 2014).

Market Share of the Big Six Energy Companies

According to Cornwall energy, the big six energy supplies provide power to over 90% of homes in the UK despite intense competition from independents. British Gas which is owned by the UK- based Centrica group is the largest supplier in the UK. It supplies more than 11 million homes with gas and other 6 million with electricity. The second company is SSE which is the second largest supplier. It is a Scottish-registered company and supplies energy to about 9 million customers. SSE is a major hydro and wind energy producer. The third largest energy company is E.ON which is owned by German E.ON AG, previously Powergen and provides energy to almost 7 million homes. EDF Energy is a fourth company which belongs to the French national provider EDF SA and supplies both gas and electricity to 6 million homes. They are also largest power producer in the UK. Npower is the fifth company and is owned by German RWE, previously Innogy, and it provides energy to 5 million homes. Lastly is Scottish power which was acquired by Spanish-based Iberdrola in 2006 and supplies electricity to 5 million homes (Pearson & Watson, 2012). The market shares of each company are summarized in the Ofgems 2014 State of the Market Assessment graph below;

Domestic electricity supply market shares

From the above graph of electricity market share, SSE gained much more than other companies between 2004 and 2014 to having around 7% market share by 2015 while on the other hand E.ON lost much by sliding form 22% market share to around 17%.

Domestic gas supply and market shares

From the above graph of gas market share, British Gas dominance has been worn down over the years because more customers switch to dual fuel tariffs with one supplier. This led to 15% decline in British Gas and subsequently growth of smaller supplies from the year 2011.

Market Structure for the Energy Industry

From the above data about UK energy industry, it is clear that it is a form of oligopoly market structure. This is in the sense that the big six energy suppliers are robust vertically integrated firms which prevent competition in the energy sector. The six as seen control large market shares thus preventing smaller energy companies from health competition. Also, the big six have placed high barriers to entry through reputational risks, regulatory barriers and pricing strategies (Advani at el,2013). The big six suppliers have increased their profits over time without efficiency improvements in their supplies meaning they use their oligopolistic behaviors to control energy prices for their benefits. Lastly, tacit coordination is seen to be a problem which assists the leading suppliers to increase the price. This prompted the industry regulator Ofgem to conduct an investigation into possible collusion in the energy market, but however, they didnt find any evidence (Advani at el,2013).

Profit-maximizing price and output of British Gas

British Gas is a major energy supplier to the UK energy industry. Since it is a dominant firm in an oligopoly, changes in their pricing mechanisms will do other small businesses to follow since it is a price leader. In this case, British Gas can maximize its profits by restricting their output in such a way that they only produce until marginal costs equal marginal revenue. However, an oligopolistic British Gas will not reach an efficient scale of production because they are not operating on their minimum average total cost since marginal cost curve and marginal revenue curve intersects before marginal cost curve intersects average total cost curve. British Gas also produce less energy than what the market demands because their marginal cost curve never intersects the market demand curve. This means that the firm lack allocative efficiency as experienced in many oligopolies (Simshauser & Laochumnanvanit,2012). This is explained in the following graph;

Quantity Supplied

Abnormal profit in British Gas oligopoly occurs when their average revenue is greater than average total cost. This gives an incentive to other firms to enter the market. Average income is equal to the market demand curve. These profits are usually not evenly distributed to consumers and end up benefiting the company alone. Price discrimination is a factor which gives the company abnormal profits, and thats why UK government need to intervene by controlling energy costs (Hall,2016).Reasons for reluctance in switching energy supplier and ways to encourage switching

The main reason why people are not switching their energy supplier is that they are happy with their current provider. Over 40% of homes are still supplied by the original supplier even after around 12years since the market was freed despite the fact that they stand a chance to save up to 300 Euros in the first year of switching. An average of 23% said that switching is a hassle while 15% argued that there is no enough difference between the suppliers which can trigger them to switch. Lastly, 10% said that they have checked other supplies and found that they are on the best deal. These statistics are summarized in the graph below done between 2012 and 2013 (Hall,2016).

Reasons for not switching supplier

However, people should be encouraged to change supplier to a cheaper because it saves their money. The average savings a year for a small house is around 140 euros, 220 euros for the average house, and around 320 euros for a large house. People should be sensitized that it is simple and much easier to switch suppliers and they stand a chance to enjoy cheap fixed rate deals. Small energy suppliers also have better customer satisfaction as compared to the big six. An example is OVO which won several uSwitch awards in 2014 including customer service and supplier of the year (Simshauser & Laochumnanvanit,2012). Impact, advantages, and disadvantages of a price cap on the energy market

The price cap in UK energy suppliers increased between the Big Six energy tariff and cheapest deals in the market from 182 in 2014 to 329. However, there was only 1.6%-point increase in electricity customers and 2% increase in gas customers who switched their suppliers despite significant savings available. Conservative party promised to cap prices for two-thirds of British household due to the rising energy bills. Ofgem will be tasked to reset the maximum price after every six months due to changes in energy supplier costs (Advani at el,2013).

Introducing price gaps has several impa...