More spark for less grief

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The Central Electricity Generating Board dominated the British electricity market for almost 50 years, representing the best of central planning. However, it is competitive markets that, whilst far from from being perfect, deliver the greatest economic benefits.

On March 27th, the lights flickered – and stayed on. That was the first day of the New Electricity Trading Arrangements. It was also the end of a story which will for ever exemplify the relative strengths and weaknesses of central planning and market forces.

The Central Electricity Generating Board dominated the British electricity industry for almost fifty years, from post-war nationalisation to privatisation. It represented the best of central planning. It was run by disinterested and highly intelligent administrators and engineers who were dedicated to the public interest. It employed the most advanced techniques of risk management and economic analysis.

Its pride and joy was the central control room of the National Grid. The engineers who worked there had details of the running costs and availability of every piece of generating plant in England and Wales. They would constantly monitor and anticipate demand and instruct plant managers to produce electricity, or stop producing electricity, by reference to what they called the ‘merit order’. The objective was to ensure that output was always achieved at the lowest possible cost.

When electricity privatisation was planned, it was seen as essential that the new arrangements reproduce the efficiencies of the merit order. There is a remarkable result in mathematical economics called the fundamental theorem of welfare economics. Margaret Thatcher and Cecil Parkinson knew it instinctively. The theorem says you can find a competitive market solution to replicate the results of any efficient planning mechanism.

And so it proved. The government’s advisers came up with a complex structure of market arrangements known as the electricity pool. Generators were required to bid in to the pool the price and quantity at which they were willing to supply, and the National Grid controllers selected the best bids. Then the pool paid out to all generators the highest price of any successful bid. You can show, not just that this scheme reproduces the results of the merit order, but that it is the only scheme that does so – making a good exercise for any economics students.

There was just one snag. The fundamental theorem of welfare economics requires not just that markets be competitive but that they be perfectly competitive. A perfectly competitive market is one in which no producer is big enough to have a significant influence on the price. But that certainly wasn’t true of the electricity market in England and Wales. The two main successors to the Central Electricity Generating Board – PowerGen and National Power – were among the largest electricity generating businesses in the world.

So prices were much higher than they would have been if the theoretical advantages of the pool had been realised. And it was the two principal generators, rather than the control room or the market, that determined how and where electricity was produced. The electricity regulator intervened, first to cajole and threaten, then to impose a cap on prices. This was a long way from the fundamental theorem of welfare economics. Next National Power and PowerGen had to dispose of some of their plant, although they did so on terms that barely reduced their market power. Finally, the government abolished the pool, and allowed buyers and sellers to make whatever contracts they liked.

So did privatisation fail? In some respects. Electricity prices have been too high, because generators were able to manipulate the pool to their advantage and because regional electricity companies made bad deals whose costs they were able to pass on to their customers. Without increasingly tough and increasingly interventionist regulation, electricity customers would have received few benefits from the creation of more competitive markets. The efficiency advantages of the merit order were indeed relinquished.

But the real merits of competitive markets do not have very much to do with the fundamental theorem of welfare economics. The weaknesses of planning are in its tendencies to centralisation, gigantism, secrecy and complacency. In retrospect, the CEGB displayed all of these. It sponsored an uneconomic nuclear energy programme. It planned in the 1960’s a massive expansion of generating capacity based around much larger plant than had been built before. None of the programme was delivered to time or budget, but it didn’t matter because we didn’t need the electricity anyway. Few of the costs of this were ever revealed, and its sponsors went on to retire with peerages and knighthoods. And it turns out that the generating plant the CEGB operated can be run perfectly well with half the number of employees that the CEGB needed.

The real benefits of competitive markets over central planning are that decisions are made on a smaller scale, and a diversity of views can be implemented. This makes the consequences of good and bad decisions more obvious. Errors can be more quickly corrected, and the expectation that individuals may be held responsible for the outcome helps judicious decision-making. The electricity industry today is messier than it was. And it is important to keep it that way. Markets are not a perfect form of economic organisation. They are just better than the alternatives.

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