E L S E V I E R PII:S0301-4215(97)00001-3

Energy Pol& T, Vol. 25, No. 4, pp. 393-399, 1997 © 1997 Elsevier Science Ltd

Printed in Great Britain. All rights reserved 0301-4215/97 $1700 + 0.00

Merger in the English electricity industry

David Kennedy Centre for the Study of Regulated Industries, CRI, 3 Robert Street, London WC2N 6BH England

This paper compares consumer prices under vertical integration and verticial separation of the electric- ity industry in England and Wales and considers the costs and benefits of mergers between electricity supply and water companies. The impact of vertical integration is important given the proposals for merger between electricity generating and supply companies in 1996. The paper concludes that there could be small benefits to consumers if competition in the electricity industry is limited. In a fully competitive industry the impact of vertical integration on the consumer is neutral. Regarding competition, vertical merger might limit the extent of new firm entry in the electricity supply market after liberalisa- tion in 1998. Inter industry merger will yield cost savings but may limit new firm entry in electricity sup- ply. © 1997 Elsevier Science Ltd. All rights reserved. Keywords: Merger; Competition; Consumer prices

Introduction

The issue of merger has recently become both important and controversial in the context of UK regulated network utilities. In the electricity industry, mergers between generat- ing and supply companies were proposed and there have been mergers between electricity supply companies and water companies. A range of issues are important when assessing the effect of a merger. There may well be associated benefits, for example lower costs through scale and scope economies. A merger may create a large firm with too much market power, or make the job of regulation more difficult, or inhibit the growth of competition; these are the possible costs of a merger. The present paper weighs up the benefits and costs of mergers in various settings.

Section 1 of the paper gives an overview of the electricity industry in England and Wales. The paper continues, in sec- tion 2, with a discussion of merger between electricity generat- ing and supply companies. One issue here is the way that a merger might affect (consumer) prices in the short-term where there is only limited competition in generation and no competition in electricity supply, this is discussed in section 2.1. After this, in section 2.2, the focus moves to the relation- ship between generator-supplier mergers and the evolution of competition in the electricity industry. In section 2.3, government policy regarding generator-supplier mergers is placed in the context of the preceding discussion. The paper finishes with a discussion of merger between electricity sup- ply and water companies. Section 3.1 considers the benefits

that water-electricity supply mergers may yield (lower costs): sections 3.2 and 3.3 outline possible consequences for the job of regulation and the evolution of competition in electric- ity supply.

Structure of the electricity industry in England and Wales

Since 1990 the electricity industry in England and Wales has experienced considerable disaggregation from the structure which preceded privatisation. In 1990 the industry was split into four components: generation, transmission, distribu- tion, supply.

Generation is the production of electricity at power sta- tions. Before privatisation, electricity in England and Wales was generated by the Central Electricity Generating Board (CEGB). The generating businesses of the CEGB were privatised as two fossil fuel generators - National Power and Powergen- and a nuclear generator, Nuclear Electric. National Power and Powergen dominate the market for generation in England and Wales, there is competition due to divestiture of capacity and entry of new Independent Power Producers.

Transmission is the conveyance of electricity from power supply points via high voltage lines. These high voltage lines together comprise the National Grid. The National Grid became a separately quoted company on the stock exchange in December 1995.

Distribution is the conveyance of electricity from supply points to consumers via low voltage lines. The distribution

394 Merger in the English electricity industry." D Kennedy

business in England and Wales was privatised as twelve businesses, each owned by a Regional Electricity Company (REC).

In addition to distributing electricity, RECs supply electric- ity. Supply is the selling of electricity provision services (eg metering) to consumers. Each REC has (statutory) local monopoly for consumers with demand less than 100 kw.

Electricity generating and supply companies do not in general trade directly with each other on a day-to-day basis. The pool is a wholesale spot market for electricity.

Generating companies sell electricity to the pool, supply companies buy electricity from the pool.

Prices in the pool vary significantly in the short-term. In order to insure against price volatility, generating companies and RECs sign futures contracts called 'Contracts for Dif- ferences'. These contracts specify the price at which a given quantity of electricity will trade between a generating company and an REC at a time in the future.

The market for electricity generation is highly concentrated and the two main generators are price setters for significant time periods: in 1995/1996 National Power and Powergen set prices for around 50% and 35% respectively of the time (MMC, 1996a; MMC, 1996b). Ongoing new firm entry and divestiture of plant by the major generators may erode some of the price setting power of National Power and Powergen.

The electricity industry is regulated by the Director General of Electricity Supply (DGES), whose duties are inter alia to: secure that all reasonable demands for electricity are met; secure that licensees can finance their licensed activities; promote competition in generation and supply.

Some monopoly aspects of the electricity industry - transmission, distribution, low user supply - are regulated by the DGES according to an RPI - X price cap.

Barriers to entry in electricity supply will be lifted from 1998 after which it is possible that a competitive market may emerge.

Vertical merger

The electricity industry in England and Wales was split verti- cally prior to privatisation in 1990/1991. In particular, electric- ity generation and supply businesses were separated. The possibility of a new structure for the electricity industry arose in 1996 with proposed vertical mergers, that is, merg- ers between generating and supply companies.

Were these mergers to go ahead, the resulting companies would be vertically integrated.

A range of issues are important when assessing the potential impact of a vertical merger in the electricity industry. One of these is the way that a merger would change market power and through this affect prices. So for example, would a merged generator and supply company be able to raise prices above what they would be with separate generating and supply companies? Would a merged generator and supply company have sufficient market power to prevent competition by deter- ring entry of new firms? These are possible negative effects of a vertical merger, against which must be set possible

benefits. What are the possible benefits of a vertical merger and to what extent will these be passed on to the consumer? The present paper answers these questions drawing on a theoretical model presented in Kennedy (1996).

The impact of a vertical merger in a given industrial structure

The impact of a vertical merger depends upon the industrial structure within which the merger takes place. For example, a vertical merger when there is monopoly in generation and supply may lead to a different outcome relative to the case where there is competition in generation and supply.

As a starting point, an industrial structure where there is an unregulated monopoly generator and a regulated monopoly supply company is assumed. This is a reasonable approxima- tion to the structure of the electricity industry in England and Wales in 1996.

It may be contended that the assumption of a monopoly generator is an unreasonable abstraction from the real situ- ation where there are two dominant firms in the England and Wales generating industries. The abstraction is valid however because the firms are capacity constrained and this has affected the way that competition between the two dominant firms has worked. Where competition is between two capacity constrained firms then each firm has price set- ting power. The England and Wales generating market has been (largely) characterised by competition between two capacity constrained firms - National Power and Powergen - with the result that each firm has set prices over a significant time period (MMC, 1996a; MMC, 1996b). In other words, each firm has been a monopolist over a significant time period and the assumption of monopoly is thus justified. In any event, the basic propositions under the monopoly assump- tion are qualitatively unchanged for different types of competi- tion in generation.

Turning to the assumption that generation is unregulated, this simply mirrors the situation in the England and Wales electricity industry. Though there are informal price controls - the generating companies agreed with the regulator not to raise prices above a certain level - these relate to prices which exhibited monopoly characteristics (see Green and New- bery, 1992 for an analysis of electricity generating prices in England and Wales).

When there is unregulated monopoly generation and regulated monopoly supply, then vertical merger is not bad for the consumer. The intuition for this is as follows. An integrated generator and supply company is a monopolist with the power to choose the profit maximising price at which to sell electricity to the consumer. With separate generat- ing and supply companies and supply regulation which allows cost to pass through from generation, then the generator can effectively set the price at which electricity is sold to consum- ers. The generator will choose the same price as the profit maximising vertically integrated company because this maximises industry profit and under supply regulation all industry profit accrues to the generator.

If there are benefits of vertical merger then this may lead

Merger in the English electricity industry." D Kennedy 395

to lower prices relative to the case where there are separately owned generating and supply companies. The benefits here might stem from scale and scope economies, though statisti- cal evidence suggests that these are limited (see Gilsdorf, 1994) as does a submission from Powergen to the MMC which states 'the degree of direct synergy...[between generat- ing and supply companies] is probably quite limited' (MMC, 1996b p. 82).

There are other possible benefits however, these stem from the fact that the cost associated with risk due to price volatility in the pool is less for an integrated than a separate supply company. There is an internal hedge against price volatility for an integrated company. This may be compared to a separate supply company which incurs costs when tak- ing out contracts for differences and bears the cost of risk for that part of its supply which is not insured by contracts for differences (companies do not contract over their whole purchase of electricity as this would risk overcontracting).

Where there are cost savings from vertical merger then the integrated company could pass on part of these of its own accord; this has actually happened in the electricity industry in England and Wales following a merger, see Elphick (1996a) for a discussion. A greater part of cost savings might be passed on to the consumer through regulation. For example, the regulator could make as a condition of merger that prices be reduced below what they would otherwise have been. This condition has been set by the regulator in the case of water industry mergers in England and Wales.

The monopoly-monopoly structure above is not relevant for the longer term and not that against which to assess merger when one stated objective of the electricity regulator is to encourage competition. Liberalisation of the electricity supply market is planned for 1998, this could lead to entry of new firms into each of what are presently franchise areas, though the extent of entry is as yet unclear. If there is no entry at all (this might be the case if there is some kind of tacit agreement between electricity supply companies, or because margins in electricity supply are low and risks are high) then, given that there are no developments in the generat- ing market, the monopoly-monopoly structure would continue to be relevant, the result holds that vertical merger is not bad and can be good for the consumer.

Under effective competition in supply, firms would compete on price in order to win customers. If this is the case, then vertical merger does not increase or reduce welfare. The result of price competition is an equilibrium price equal to cost, this is the case whether there is vertical merger or not. If vertical merger gives the merged firm an advantage, then equilibrium price is equal to the cost of the non-merged firms and the merged firm enjoys high profit relative to its competitors. Without vertical merger the equilibrium price would still equal the cost of a non-merged firm, so vertical merger does not have adverse or beneficial effects on the consumer in this situation.

The outcome is never optimal if firms have power to set generation prices, because in setting prices firms act against the interests of the consumers. The textbook case of this is

the monopolist who raises price to make profit at the expense of the consumer. This price distortion is the most important as regards the consumer in the England and Wales electric- ity industry given the degree of monopoly power and the fact that generation costs comprise approximately 50"/0 of a typical low user bill, hence attempts by the DGES to encour- age greater competition in generation.

There is increasing competition in the England and Wales generating market. For example, Eastern Electricity has recently bought plant which will give it a forecast 9% share of the England and Wales generating market and reduce the market share of National Power and Powergen to 24% and 22"/0 respectively, l Having said this, changing market shares may not erode price setting power of the two dominant generators; prices in the electricity pool are determined by owners of non-baseload plant, this will still largely be in the hands of National Power and Powergen. Newbery (1996) suggests on the basis of simple extrapolation that, after divestiture of plant to Eastern, National Power and Power- gen will continue to set price for around 68% of the time. If this scenario is played out, then the generating industry will not be competitive. Nevertheless, this is not the only possible scenario, it is worth noting the outcome of vertical merger should a fully competitive generating market emerge.

With full competition in generation and supply then price will be equal to cost in both generating and supply markets and prices will be lower than under any other industrial structure. 2 This result holds for separately owned generating and supply companies and vertically merged companies. Where there is full competition in generation and supply no firm (generating, supply or merged generating and supply) has the power to raise price above cost in order to increase profit. If a merged firm enjoys a cost advantage (through scope economies or relatively efficient hedging) then it will receive high profits relative to its competitors but not at the expense of consumers; the equilibrium price is equal to the cost of a non-merged firm whether or not there is a merged firm in the market.

The dynamics of competition: will merger affect emerging competition?

The above discussion was about vertical merger in the context of various industrial structures. The approach was to assume a structure (eg monopoly in generation and supply) and analyse vertical merger within that structure. Given that there is regulatory failure (so that the regulator fails to mimic perfectly the pressures created by the market) then the preferred structure is one where there is competition in both genera- tion and supply. Within this preferred structure vertical merger does not have adverse consequences.

The present structure in the England and Wales electric- ity industry is such that there is limited competition in genera- tion and regulated monopoly in supply. Structure is changing with new firms gaining market share in generation and full

~Source: OFFER Press Release, 25/6/96. 2Assuming that where there is regulation there is some regulatory failure (regulation does not perform as well as competition).

396 Merger in the English electricity industry." D Kennedy

liberalisation of the supply market planned for 1998. The way that structure evolves may be contingent on whether or not there is vertical merger.

One way in which the electricity industry could become fully competitive is through new firm entry in generation and supply? Entry of new firms depends on the interaction between three markets: generation, supply, contracts for differences. So for example, entry in generation requires a well function- ing contracts for differences markets (so new firms are not dissuaded from entering on grounds of risk) and a supply market where there is sufficient demand for electricity from new generators.

Without further entry in supply and some supply companies tied to generating companies through vertical merger, then new firms may not enter the generating market because of insufficient demand for their output. Having said this, without further entry in supply and with two vertical mergers (as proposed in 1996) there would still be ten supply companies purchasing electricity in England and Wales. Also, this assumes that a merged generating company satisfies the total demand of its supply company, an assumption which is not valid; it is likely that were a vertical merger to go ahead the supply company of the merged business would buy electricity from other generators as well as its own (MMC, 1996a; MMC, 1996b).

There are already a number of firms in the generating market with ongoing changes in market share. Taking into account divestiture, new plant under construction and planned new plant, the MMC forecasts the following market shares for 2000/2001: National Power (21%); Powergen (17%); Nuclear (24%); Interconnectors from Scotland and France (10%); pumped storage (1%); further disposals of plant by National Power and Powergen to be bought by other firms (6%); Independent Power Producers (21%).

The way that the pool has worked is such that firms with non-baseload capacity have price setting power. Though there may be changing shares in the generating market as a whole, National Power and Powergen will continue to dominate non-baseload supply and may continue to set prices. This is not however something that would necessarily be changed by further new entry in generation. In fact, further entry in generation might have adverse welfare effects due to the wasteful duplication of set-up (generating plant) costs (Green, 1996). Whether price setting power is eroded depends on any future divestiture, bidding strategies of new players in the generating market, and the extent to which competition in baseload supply erodes price setting power in the pool. These areas may be viewed independently from the issue of verti- cal merger; vertical merger will not have a major impact on the evolution of competition in the generating market.

Whether or not there is further entry in supply depends on (at least) three factors: margins in the supply market; risk associated with entry (which depends on the way that the contracts for differences market operates); the way that incumbents defend their position and the way that a merged

3Another way is through divestiture, this is discussed later in the paper.

incumbent might use any cost advantages to defend its posi- tion.

Regarding margins in the supply market, it is not clear at the moment whether these are sufficient to encourage entry. Electricity supply companies suggest that margins are low, that firms will not enter and that the expense of liberalising the supply market cannot be warranted. The electricity regula- tor suggests that it is in the interest of the supply companies to say that liberalisation cannot be warranted because if it were to go ahead it would result in an end to monopoly status of these companies. Contrary to the suggestions of the supply companies, the regulator has argued that margins are sufficient to attract new firms to the industry after 1998 and that liberalisation can be warranted.

The contracts for differences market must function well if entry in supply is to take place. New firms must be able to enter contracts for differences in order to insure against risk. If the vertical mergers proposed in 1996 were to go ahead then two generating companies which were major players in contracts for differences would leave the market and contract- ing might be harder and less advantageous to new supply firms. This is not a strong argument against vertical merger however because even with the go ahead of the two proposed mergers, the contracts for differences market is forecast to grow by around 15% of its present size by the years 2000/ 2001 (MMC, 1996a; MMC, 1996b ).

If incumbent supply companies undertake strategies designed to deter entry then new firms may not enter the supply market. One way in which an incumbent firm may deter entry is through predatory pricing. Under a crude definition, predatory pricing is the setting of price below cost which leads to short-term losses, no entry of new firms, and long run monopoly profits. Vertical merger resulting in cost advantage to the merged firm could lead to behaviour which would have the same effect as predatory pricing; the vertically merged firm would be able to price below the cost of potential entrants to supply. Whereas under predatory pricing the incumbent incurs short-term losses, with incumbent cost advantage entry may be deterred without any short- term losses.

The scope for pricing to deter entry depends on the cost advantage accruing to a merged firm, this in turn depends on the extent of scope economies and relative efficiency of internal hedging. It was stated above that empirical evidence shows the extent of scope economies to be small. Internal hedging is relatively more efficient than contracting because supply firms do not contract to cover the whole of their output (this would lead to the possibility of overcontracting) and thus bear some risk with associated cost. Relative efficiency of internal hedging depends on the cost of writing and undertaking contracts for differences and the bargaining process underlying the contracts. As contracting costs increase then internal hedging becomes relatively more efficient. The trading price in a contracts for differences must lie around the expected pool price. A generator may be prepared to accept a price below the expected pool price rather than not contract at all. Likewise, a supply company may be prepared

to pay a price above the expected pool price rather than not contract at all. If the supply company contracts at a price above expected pool price then internal hedging is efficient relative to external hedging through contracting. As there is less competition in the generating market then the likelihood that contract price lies above expected pool price increases.

Another means by which firms may try to deter entry is through price discrimination, that is, an integrated supply company could sell electricity to its own company at a lower price than to competing supply companies. This is something that can be regulated against, for example, through account- ing separation of generating and supply businesses in a merged company. Under accounting separation a regulator can ensure that there is no price discrimination. Accounting separation may fail however, because a regulated firm knows more about its cost than does the regulator and may exploit this fact. 4 If accounting separation does fail then an integrated generator might charge a relatively high price to non- integrated supply companies, raising the costs of these firms to an extent that would make them unprofitable. There are two points to note here: if there is competition in generation then scope for price discrimination is eroded, if a generating firm were to charge a high price, then supply companies would go and buy electricity elsewhere; failure of accounting separation is not something that is exclusively related to the issue of vertical integration, there is more scope for price discrimination and entry deterrence through monopoly electricity distribution businesses.

So, vertical merger may affect the evolution of competi- tion in the electricity supply market. This is more likely as the cost advantage of vertically merged firms increases. Though cost advantages may be small - due to the presence of only a small degree of scope economies, small costs associated with contracts for differences, contract prices which due to competition in generation are not far above the expected pool price - in combination with low margins (though the level of margins is not clear) and possible price discrimina- tion and consumer loyalty - which means that new firms must offer price reductions to enter the market - a vertically merged firm may be able to deter entry in the supply market and thus stop the development of competition.

Summary

The common ownership of generating and supply companies not bad per se; for any given industrial structure vertical merger is not welfare reducing and may be welfare improv- ing. There may however be a case against vertical merger on the basis that it could inhibit the growth of competition in the electricity industry, undermining incentives for new firms to enter in both generating and supply.

One important result of a vertical merger is that this may give the merged firm a cost advantage, either due to scope economies or increased efficiency in hedging against risk. A vertically merged firm would be able to practice entry deter- rence in the electricity supply market, this is in opposition to

Merger in the English electricity industry: D Kennedy 397

the aim of the regulator which is to increase competition in supply.

This is likely to be the major effect of vertical merger as regards competition; though there could be feedback so that lack of competition in the supply market would cause lack of competition in the generating market, ongoing divestiture and new entry in the form of plant already constructed/ under construction/planned, should lead to greater competi- tion in generation. Other factors may inhibit growth of competition in generation, but these unrelated to issue of vertical merger.

Finally, it is worth noting that consumer benefits from vertical merger are limited: in the best case scenario of competi- tion in generation and supply, consumer prices are equal whether one firm is vertically integrated or not; where sup- ply is regulated, any cost reductions could be appropriated for the consumer by the regulator, though the extent of cost reductions may be small and the ability of the regulator to pass these on may be limited.

Government policy

The MMC recommended that the proposed vertical mergers between National Power and Southern Electric and between Powergen and Midlands Electricity should go ahead subject to the fulfilment of certain conditions. The conditions were based on the recognition that the mergers may work against the growth of competition and included the supply companies involved in the proposed mergers selling any interests that they owned in generating companies (the supply companies had interests in some independent power producers), this was to maintain competition in the generating market. The MMC did not reach a consensus regarding the proposed mergers; there was a dissenting member of the MMC panel reporting on the mergers who argued that the electricity industry was not yet sufficiently competitive and that to allow vertical merger would inhibit the further growth of competition.

The final decision over the proposed mergers rested with the Department of Trade and Industry, The Department did not follow the recommendation of the MMC: lan Lang, President of the Board of Trade and Secretary of State for Trade and Industry, stated that he had taken into account findings of MMC but would not allow the proposed merg- ers to go ahead because he thought that they would be bad for competition given the state of the market. Concerning the future, Mr Lang left open the possibility of vertical merger suggesting that he found it not inherently objection- able. 5

The last point - that vertical merger is not regarded as inherently objectionable - is illustrated by the approval of moves to create vertically integrated companies, notably Eastern Electricity. The discussion in the present paper has suggested that vertically integrated companies are not objectionable, though vertical mergers might have adverse effects on the evolution of competition in electricity supply.

4See Hardt (1995) lbr a discussion of accounting separation failure. ~Source: DII Press Release, 24/4196.

398 Merger in the English electricity industry: D Kennedy

On the other hand, there is no long-term benefit of vertical merger should a competitive electricity market emerge. The only cost of the decision to reject merger proposals is short- term benefits which might accrue due to synergy between generating and supply companies. Though these might have been passed on to some degree to consumers, evidence sug- gests that the magnitude of these benefits is small.

Inter industry merger

Recently there have been inter industry mergers between water and electricity supply companies, for example, Nor- web and North West water merged to form United Utilities; South Wales Electricity merged with Welsh Water. The benefit of inter industry merger is cost reduction. This must be offset against other possible effects such as possible loss of information useful to the regulator, and inhibition of competi- tion in the electricity supply market. Each of these is now discussed in turn.

Benefits of inter industry merger

There are a number of sources for costs reductions from an inter industry merger. An inter industry merger will result in the realisation of economies of scope; customers of a merged water and electricity supply company may be billed in com- mon and better use may be made of capacity. In addition to this, a merger between a water company and an electricity supply company can lead to efficiency gains because the merged companies can transfer best practice over common skills. There are likely to be benefits of synergy in a merged water and electricity supply company, for example, where there is a need to dig up a road for electricity and water repairs, the road need only be disrupted once as opposed to twice. Additional benefits which come from inter industry merger include increased tax efficiency and more efficient treasury management, Estimates by United Utilities of the combined effect of these advantages is a cost saving worth £140 million by 1999/2000, to be distributed between shareholders and consumers (Elphick, 1996b).

Inter industry merger, information loss and comparative competition

Inter industry merger could cause difficulty for regulators in obtaining industry specific data, eg the electricity regulator may have difficulty gaining information relating to the costs of the electricity supply business in a merged inter industry firm. This would create a difficulty because effective regula- tion is dependent upon the regulator having good informa- tion about a company's costs. The way around this problem is to ring fence companies within an inter industry group and where costs are joint to businesses in a merged company, to make sure these are allocated appropriately. To the extent that ring fencing can be made to work effectively, informa- tion about the businesses of a merged firm can be separated. As discussed in the context of electricity generating and supply companies though, accounting separation is not always effective, and firms transfer funds between businesses. In

addition to problems enforcing accounting separation, appropriate allocation of joint costs could be an area of controversy. A company would try to allocate costs to its regulated water business rather than to its electricity supply business operating in a liberalised market. Where joint costs relate to administration, a separate company may be set up to sell services to the water and electricity supply businesses.

The presence of a number of firms in an industry provides information which can be used in the process of regulation. This can be illustrated in an example where it is assumed that there are two firms in an industry. It is further assumed that each firm's cost depends on the level of effort chosen by the firm and factors exogenous to the firm; the regulator observes each firm's cost; the regulator cannot directly observe the level of effort chosen by each firm. In this situation the regulator can gain information about a firm's chosen level of effort by looking at the two firms' relative costs. If the two firms faced are subject to exactly the same exogenous cost influencing factors, then any difference in the firms' costs purely reflects differences in the levels of effort chosen by the two firms. If a firm is not making as much effort as it might to minimise costs then regulation can be made to reflect this by, for example, the setting of a tight price cap relative to other firms.

Implementation of regulation along the lines of the above example requires that the regulator be able to compare costs across companies. An inter industry merger may obscure information regarding an electricity supply company, thus reducing the amount of information available to a regulator carrying out a comparative competition exercise. Again, the way around this is for the businesses of a merged inter industry firm to be ring fenced, though it must be noted that ring fencing may not be fully effective.

Inter industry merger and competition

In the discussion of vertical merger in the electricity industry it was suggested that a merged supply company may have a cost advantage over potential competitors and may use this to deter entry to the supply market by new firms. The same point applies in the case of a merger between a water company and an electricity supply company; this would give the merged electricity supply company a cost advantage which could stop the growth of competition in the electricity supply market.

There is an additional factor here, that the merged firm might subsidise the (potentially competitive) electricity sup- ply company with funds from the (monopoly) water company, allowing the electricity supply company to practice preda- tory pricing. Again, though a regulator would attempt to prevent this type of behaviour, there may be some degree of regulatory failure and companies may cross-subsidise competi- tive activities.

Even if the regulator is fully able to prevent a company from cross-subsidising its electricity supply business, the lat- ter will still have a cost advantage over potential competitors due to the factors listed above (scope economies, synerg2~ benefits etc.). This cost advantage is likely to be h~rge relative

Merger in the English electricity industry." D Kennedy 399

to the cost advantage enjoyed by a vertically merged electric- ity supply company (where scope economies are limited) and it provides scope for entry deterrence. Thus water-electricity merger may stop competition taking hold in the electricity supply market. This is not to say water electricity merger should be barred, because a joint water electricity monopoly may be the most efficient means of providing these services. As is often the case, there is a trade-off between the benefits of having a monopoly firm (full exploitation of scope economies) and the benefits of competition.

Conclusion

This paper set out to discuss mergers in the network industries. First of all vertical merger in the electricity industry was considered. For any given industrial structure vertical merger does not increase, and may reduce (where competition in electricity supply is limited), consumer prices.

The electricity industry is in a period of transition and vertical merger may affect the evolution of competition. Though vertical merger could affect competition in genera- tion, sufficient companies for new generators to trade with. There is increasing competition in generation through new firm entry and divestiture. Actually, new firm entry may be undesirable given the present level of demand. Any further growth in generating competition depends on other factors - such as the ownership of non-baseload plant - which are not related to the issue of vertical merger.

Vertical merger may prevent competition in electricity supply if it leads to a cost advantage for the merged firm. The best outcome for the consumer is one with competition in generation and supply. Vertical merger does not impact upon welfare in this situation though it may prevent this situation coming about by preventing entry in supply.

The cost of government decisions to prevent proposed vertical mergers is the foregoing of short-term synergy benefits. It is likely that these are of small magnitude. Barring verti- cal merger is consistent with the longer term objective to

achieve a competitive electricity supply market. If competi- tion in supply comes about, then there is no cost to the consumer having no vertically merged firms in the market.

In the case of inter industry merger, the benefits in terms of cost savings may be quite considerable. There could be information loss resulting from the merger and making regula- tion harder, though this could be avoided by ring fencing of merged companies. Inter industry merger may give a merged electricity supply company a cost advantage which it could use to deter entry of other firms to the market. Allowing mergers in this context is not consistent with the objective to create a competitive electricity supply market. This does not mean that inter industry merger should be barred, but the lower costs stemming from having only one firm must be set against the lower costs which might result from competition.

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