(The author is a Reuters columnist. The opinions expressed are his own.)
LONDON, Oct 29 (Reuters) - Britain's gas and electricity retailers will have to be much more transparent about how they buy wholesale supplies on behalf of their customers if they are to defuse the political storm that has erupted over energy bills and restore trust among bill-payers.
In a thoughtful editorial published on Monday, the Financial Times, which has fiercely criticised demands by the opposition Labour Party for a temporary price freeze, made a strong call for perestroika (reconstruction) in the energy market ("Reform trading rules and re-evaluate green subsidies" Oct 27).
But what the energy markets needs first is more glasnost (openness). Before the market can be sensibly reformed its cost structure and profitability need to be properly understood.
Remarkably no one seems to know how much the country's six dominant energy retailers are paying for the power and gas they buy on behalf of customers, and whether they are securing a good deal.
In the debate over whether wholesale energy costs, environmental obligations, or profiteering are pushing bills to record levels, even the regulator, Ofgem, and industry experts are unable to state what price the retailers are paying for the power and gas they buy on wholesale markets, and whether it is reasonable.
Ofgem claims rising wholesale costs account for only a tiny fraction of the recent round of increases, based on a model about how the retailers lock in supplies and prices in the forward market. The companies dispute the regulator's calculations. "The Ofgem methodology is at best an approximation," according to Centrica.
Ofgem and the six major energy retailers agree the profit margin on their supply business is around 5 percent, and that this is defensible, though it is higher than many supermarkets achieve.
But the retailers are all power or gas producers, and buy much of the electricity and gas that they supply from their own production and trading arms, or from one other, via bilateral deals.
No one seems to know the details of those deals, whether they are reasonable, and what profit margins the major energy retailers are making in their connected generation and production businesses.
The prices at which the production/generation/trading arms of the energy suppliers sell gas and electricity to their associated distribution/retail arms provide enormous scope to shift profits from one part of the business to another to minimise tax liabilities and unwanted attention from the regulator and politicians.
"Vertical integration further undermined transparency because it was not easy to see where the profits were being earned," Oxford University's Dieter Helm, one of the country's foremost experts on energy pricing, wrote recently" (http://www.dieterhelm.co.uk/node/1362).
"Was it the seller (the generator) or the supplier (the buyer) who was making the money - when they were the same company?" he added. "It remains the case now that understanding the profits of the vertically integrated companies is extremely complex."
Transfer pricing is where vertically integrated companies get most creative. It is how companies minimise tax bills, down to zero in the case of some multinationals. It is also how Britain's North Sea oil producers minimised their tax bills in the 1980s, by shifting profits from (higher-taxed) offshore production operations into (lower-taxed) onshore refining businesses.
Vertically integrated businesses always claim transactions are conducted on commercial terms on an arms-length basis, and keep copious records and accounts to prove it. Policing transfer pricing arrangements is notoriously difficult.
But what is disturbing is that neither the energy regulator nor the experts seem to have any information on whether the transfer prices are reasonable, and whether the retailers are acting in the best interests of customers in buying forward power and gas supplies.
For gas producers, electricity generators and retailers contract terms and hedging strategies are proprietary and confidential. In this case, however, there are several compelling reasons for regulators to pierce the veil of commercial confidentiality.
Unlike other businesses, the supply of power and gas is an essential utility, from which customers cannot opt out.
In Britain, the business is an effective oligopoly. Virtually all households buy power, gas or both from just six companies. Efforts to promote the entry of more retailers have largely failed which suggests that there are formidable barriers to competition.
Vertical integration creates substantial opportunities for profit-shifting. "The wholesale market is only an indication for energy prices, not a definitive guide, because electricity is predominantly bought and sold through bilateral trades that aren't public," according to the Labour Party's policy review document on "Real Energy Market Reform" (http://www.labour.org.uk/uploads/57e4ad64-60c7-31e4-35ce-400ed575ed04.pdf).
Utility, oligopoly, vertical integration and the absence of a transparent and liquid wholesale market all call for heightened scrutiny from regulators and the government.
Ultimately utilities hedge forward power and gas prices on behalf of their customers, and those customers have a right to know that the hedging programmes are being conducted fairly and cost effectively.
"The electricity market is never going to be perfectly competitive," according to Helm. "It is riddled with market failures and it will always tend to an untidy mix of larger oligopolies and a smaller fringe. It will always have regulation looming over it."
BRING BACK THE POOL
In the 1990s, Britain had a compulsory wholesale electricity market called the Power Pool. Generators were required to sell almost all their production into the market, and retailers to buy from it. It provided a transparent and liquid market.
Labour's policy review would recreate the pool, which the party abolished during its last term in government. "We would force the energy companies to pool the power they generate and to make it available to any retailer, in an attempt to open the market and to put downward pressure on prices" the party has proposed.
The party's headline-grabbing proposal for a 20-month price freeze has been condemned by energy experts, the media and its political opponents, though it is popular with voters, especially in the marginal constituencies that will be the battleground at the next set of elections, due in 2015.
But the party's other proposals, especially for recreating the power pool and reforming Ofgem, command much broader support, and have a good chance of being put into practice.
"Labour is right to propose a return to a pool model," according to Helm, who is strongly critical of other aspects of the party's energy strategy.
Thinking in the governing Conservative and Liberal Democrat parties appears to be evolving along similar lines. Both want to use greater competition to hold price increases down.
"I am frustrated about the Big Six," Conservative Prime Minister David Cameron said on Monday. "I want to see the big 60; I want to see many more energy companies."
Some version of the power pool, a new form of wholesale gas and electricity market, where producers and buyers will be compelled to transact most sales and purchases in a transparent forum, now seems inevitable.
Helm and others have also questioned whether the major energy suppliers have the right incentives to invest in new capacity and an adequate spare capacity margin. Capacity margins in the power generation market have shrunk significantly in the past decade, as power generators have declined to invest in power plants other than subsidised wind farms.
But Helm believes that is because the companies have the wrong incentives. "No rational capitalist would ever deliberately create excess supply; since the excess would overhang the market and depress prices," he explained.
The current electricity trading arrangements "creates the very special incentive for the oligopolists," he went on. "The best of all possible worlds is where nobody invests. As supply and demand close up, the price spikes upwards, and supernormal profits result."
"This is just where we are heading," Helm concluded. In fact, Britain would already have experienced a power crunch if the recession had not slowed the growth in power demand.
The solution is a properly functioning capacity market, to replace the flawed one which existed in the 1990s and was then scrapped rather than reformed.
If Helm is right, the Big Six are under-investing and driving prices and profits higher in the generation business, then selling costly wholesale power to their (captive) retail businesses, ensuring customers are over-charged.
The fact the government, the regulator and outside experts do not know whether this is happening shows why more openness is needed to restore trust and form the basis for sustainable reforms - glasnost before perestroika.
(Editing by James Jukwey)